ANNEXURE 6 DAVIS TAX COMMITTEE: SECOND … BEPS Final... · - the inclusion of the PPT rule or; 3 OECD/G20 Base Erosion and Profit Shifting Project “Preventing the Granting of Treaty

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ANNEXURE 6

DAVIS TAX COMMITTEE: SECOND INTERIM REPORT ON BASE EROSION

AND PROFIT SHIFTING (BEPS) IN SOUTH AFRICA*

SUMMARY OF DTC REPORT ON ACTION 6: PREVENTING THE GRANTING

OF TREATY BENEFITS IN INAPPROPRIATE CIRCUMSTANCES

Treaty abuse rules entails the use of treaty shopping schemes, which involve

strategies through which a person who is not a resident of a State attempts to

obtain benefits that a tax treaty concluded by that State grants to residents of

that State, for example by establishing a letterbox company in that State. The

OECD/G20 2015 Final Report covers various recommendations to curtail treaty

abuse.

Currently, the main specific treaty provision that is applied in South Africa’s

treaties to curb conduit company treaty shopping is the “beneficial ownership”

provision as set out in article 10, which deals with dividends, article 11 which

deals with interest and article 12 which deals with royalties. However the

effectiveness of the beneficial ownership provision in curbing treaty shopping is

now questionable in light of certain international cases such as the decisions in

Canadian cases of of Velcro Canada Inc. v The Queen1 and Prevost Car Inc. v

Her Majesty the Queen2. Paragraph 12.5 of the Commentary on Article 10

provides that: “whilst the concept of “beneficial ownership” deals with some

forms of tax avoidance (i.e. those involving the interposition of a recipient who

is obliged to pass on the dividend to someone else), it does not deal with other

cases of treaty shopping and must not, therefore, be considered as restricting in

any way the application of other approaches to addressing such cases” (such

as those explained below). Nevertheless, the OECD does not recommend that

the beneficial ownership provision should be completely done away with. The

provision can still be applied with respect to income in articles 10, 11 and 12 but

it cannot be relied on as the main provision to curb treaty shopping.

Where that is the case, in the South African context, it is important that

SARS should address the practical application or implementation of the

tax treaty by coming up with measures of how a beneficial owner is to be

determined. This could be achieved by introducing measures such as:

* DTC BEPS Sub-committee: Prof Annet Wanyana Oguttu, Chair DTC BEPS

Subcommittee (University of South Africa - LLD in Tax Law; LLM with Specialisation in Tax Law, LLB, H Dip in International Tax Law); Prof Thabo Legwaila, DTC BEPS Sub-Committee member (University of Johannesburg - LLD, ) and Ms Deborah Tickle, DTC BEPS Sub-Committee member (Director International and Corporate Tax Managing Partner KPMG).

1 2012 TCC 57.

2 2008 TCC 231.

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o Beneficial Ownership Certificate;

o Tax Registration Form;

o Permanent Establishment Confirmation Form.

o A definition of beneficial ownership in section 1 of the Income Tax

Act, which is in line with the treaty definition as set out in the

OECD MTC.

(1) OECD Recommendations for the design of domestic rules to prevent

the granting of treaty benefits in inappropriate circumstances

To prevent the granting of treaty benefits in inappropriate circumstances, the

OECD notes that a distinction has to be made between:

a) Cases where a person tries to circumvent the provisions of domestic tax

law to gain treaty benefits. In these cases, treaty shopping must be

addressed through domestic anti-abuse rules.3

b) For cases where a person tries to circumvent limitations provided by the

treaty itself, the OECD recommends treaty anti-abuse rules, using a three-

pronged approach:

(i) The title and preamble of treaties should clearly state that the treaty

is not intended to create opportunities for non-taxation or reduced

taxation through treaty shopping.4

(ii) The inclusion of a specific limitation-of-benefits provisions (LOB

rule), which is normally included in treaties concluded by the United

States and a few other countries

(iii) To address other forms of treaty abuse, not being covered by the

LOB rule (such as certain conduit financing arrangements), tax

treaties should include a more general anti-abuse rule based the

principal purposes (PTT) rule.

The OECD acknowledges that each rule has strengths and weaknesses and

may not be appropriate for all countries.5 Nevertheless, the OECD recommends

that at a minimum level, to protect against treaty abuse, countries should

include in their tax treaties an express statement that their common intention is

to eliminate double taxation without creating opportunities for non-taxation or

reduced taxation through tax evasion or avoidance, including through treaty

shopping arrangements.6 This intention should be implemented through either:

- using the combined LOB and PPT approach described above; or

- the inclusion of the PPT rule or;

3 OECD/G20 Base Erosion and Profit Shifting Project “Preventing the Granting of Treaty

Benefits in Inappropriate Circumstances Action 6: 2015 Final Report (2015) in para 15. 4 OECD/G20 2015 Final Report on Action 6 in para 19.

5 OECD/G20 2015 Final Report on Action 6 in para 21

6 OECD/G20 2015 Final Report on Action 6 in para 22.

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- the inclusion of LOB rule supplemented by a mechanism (such as a

restricted PPT rule applicable to conduit financing arrangements or

domestic anti-abuse rules or judicial doctrines that would achieve a

similar result) that would deal with conduit arrangements not already

dealt with in tax treaties. 7

Recommendations for South Africa regarding the above measures

Where taxpayers circumvent the provisions of domestic tax law to gain treaty

benefits, treaty shopping must be addressed through domestic anti-abuse rules

However to prevent treaty override disputes the OECD recommends that

the onus is on countries to preserve the application of these rules in their

treaties.

South Africa should ensure it preserves the use of the application of

domestic ant- avoidance provisions in its tax treaties.

On the common intention of tax treaties:

It is recommend that in line with this recommendation, South Africa

ensures that all its treaties refer to the common intention that its treaties

are intended to eliminate double taxation without creating opportunities for

non-taxation or reduced taxation through tax evasion or avoidance,

including through treaty shopping arrangements. The costs and

challenges of re-negotiating all treaties will be alleviated by signing the

multilateral instrument that is recommended under Action 15 which will act

as a simultaneous renegotiation of all tax treaties.

Feasibility of applying the LOB provision in South Africa

The proposed LOB is modelled after the US LOB provision. Essentially,

the LOB provision requires that treaty benefits (such as reduced

withholding rates) are available only to companies that meet specific tests

of having some genuine presence in the treaty country. However such an

LOB provision has not been applied in many DTAs other than those

signed by the USA, and even then, the provisions vary from treaty to

treaty. South Africa for instance has an LOB provision in article 22 of its

1997 DTA with the USA.8 The structure of the LOB provision as was set

out in the September 2014 the OECD Report9 on Action 6 was however

criticised for its complexity. Even in the US, application of the LOB has

given rise to considerable difficulties in practice and is continuously being

7 OECD/G20 2015 Final Report on Action 6 at 21.

8 Published in Government Gazette No. 185553 of 15/12/1997.


Benefits in Inappropriate Circumstances Action 6: 2014 Deliverable” (2014).

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reviewed and refined.10 In its 2015 Final Report, the OECD considered

some simplified versions of LOB provisions to be finalised in 2016.11

If the simplified versions of the LOB provision are found feasible when

complete, South Africa should consider adopting the same.

Feasibility of applying the PPT test in South Africa

The PPT rule requires tax authorities to make a factual determination as

to whether the principle purpose (main purpose) of certain creations or

assignments of income or property, or of the establishment of the person

who is the beneficial owner of the income, was to access the benefits of

a particular tax treaty.

As alluded to above, the factual determination required under the

“principle purpose test” is similar to that required to make an “avoidance

transaction” determination under the GAAR in section 80A-80L of the

Income Tax Act – in particular, whether the primary purpose of a

transaction (or series of transactions of which the transaction was a part)

was to achieve a tax benefit, broadly defined. Since the two serve a

similar purpose, the GAAR can be applied to prevent the abuse of

treaties. Based on that one could argue that there is no need for South

Africa to amend its treaties to include a PPT test since the GAAR could

serve a similar purpose. Nevertheless, much as the OECD Final Report

clearly explains that domestic law provisions can be applied to prevent

treaty abuse, there could be concerns of treaty override if South Africa

applies it GAAR in a treaty context. Besides South Africa’s GAAR may

not be exactly worded like a similar provision with its treaty partner. It is

thus recommended that South Africa inserts a PPT test in its tax treaties.

Required re-negotiation of treaties can be effected by signing the

Multilateral Instrument that could have a standard PPT test as is

recommended in Action 15 of the OECD’s BEPS Project.

(2) OECD Recommendations regarding other situations where a person

seeks to circumvent treaty limitations

The OECD recommends targeted specific treaty anti-abuse rules fully

discussed in paragraph 4.2 of the report below.

It is also recommended that South Africa ensures its tax treaties also

cover the targeted specific treaty anti-abuse rules in specific articles of

its tax treaties (as pointed out in the OECD Report discussed in the

attached) to prevent treaty abuse where a person seeks to circumvent

treaty limitations. For example:

10

PWC “Comment on DTC BEPS First Interim Report (30 March 2015) at 20. 11

OECD/G20 2015 Final Report on Action 6 in para 25.

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(3) OECD recommendations in cases where a person tries to abuse the

provisions of domestic tax law using treaty benefits

The OECD notes that many tax avoidance risks that threaten the tax base are

not caused by tax treaties but may be facilitated by treaties. In these cases, it is

not sufficient to address the treaty issues: changes to domestic law are also

required (see discussion in paragraph 4.3 of the Report below).

- The OECD notes that its work on other aspects of the Action Plan, in

particular Action 2 (Neutralise the effects of hybrid mismatch

arrangements), Action 3 (Strengthen CFC rules), Action 4 (Limit base

erosion via interest deductions and other financial payments) and

Actions 8, 9 and 10 dealing with Transfer Pricing has addressed many

of these transactions. 12

- The DTC recommendations in respect to each of these Action Points is

covered in the DTC Reports that deal with the same.

(4) OECD recommendations on tax policy considerations that, in

general, countries should consider before deciding to enter into a

tax treaty with another country or to terminate one

South Africa should also take heed of the OECD recommendations

on tax policy considerations that, in general, countries should

consider before deciding to enter into a tax treaty with another

country or to terminate one. These are discussed in paragraph 4.5 of

the Report below.

OTHER RECOMMENDATIONS ON TREATY SHOPPING FOR SOUTH

AFRICA

Treaty shopping and tax sparing provisions

South Africa’s treaties with tax sparing also encourages “treaty shopping”.13

Generous tax sparing credits in a particular treaty can encourage residents of

third countries to establish conduit entities in the country granting the tax

incentive.14

It is acknowledged that tax treaties are not generally negotiated on tax

considerations alone and often countries’ treaty policies take into

account their political, social and other economic needs.15 Nevertheless,

12

OECD/G20 2015 Final Report on Action 6 in para 54. 13

H Becker & FJ Wurm Treaty Shopping: An Emerging Tax Issue and its Present Status in Various Countries (1988) 1; S Van Weeghel The Improper Use of Tax Treaties with Particular Reference to the Netherlands and The United States (1998) 119.

14 B Arnold & MJ McIntyre International Tax Primer (2002) at 53.

15 Weeghel at 257-260.

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care should be taken to adhere to international recommendations when

designing tax sparing provisions, so as to prevent tax abuse. The OECD

recommends that such designs should follow the form set out in its 1998

Report on Tax Sparing.

The problem in the older treaties may be resolved by renegotiation of the

treaty or through a protocol. The protocol should, for instance, ensure

that the relevant tax sparing provision refers to a particular tax incentive

and should contain a sunset clause or expiry date to ensure that it is not

open to abuse.16

As the process of removing or modifying existing tax sparing provisions

to prevent such abuses is often slow and cumbersome,17 South Africa’s

legislators should ensure that future tax sparing provisions are drafted

circumspectly.

It is thus desirable for South Africa to adhere to the OECD’s

recommendations and best practices in drafting tax sparing provisions.

All the obsolete tax sparing provisions should be brought up to date with

the current laws if they are still considered necessary.

Low withholding tax rates in tax treaties encourage treaty shopping

A number of withholding taxes have been introduced in South Africa.18 It is

hoped that these will be instrumental in eliminating base erosion. Treaties with

low tax jurisdictions with zero or very low withholding tax rates have been a

major treaty shopping concern for South Africa. However measures are

underway to adopt South Africa’s its tax treaty negotiation policy to cater for the

new policy on withholding taxes. Currently, all tax treaties with zero rates are

under renegotiation so that they are not used for treaty shopping purposes.

It is recommended that when re-negotiating the new limits for treaty

withholding tax rates, caution is exercised since high withholding taxes

can be a disincentive to foreign investment. Equilibrium must be

achieved between encouraging foreign investment and protecting South

Africa's tax base from erosion.

Treaty Shopping: Accessing capital gains benefits

A resident of a country which has no DTA or a less beneficial DTA with South

Africa could make an investment in a property holding company in South Africa

via a country, such as the Netherlands, in order to protect the eventual capital

16

RJ Vann & RW Parsons “The Foreign Tax Credit and Reform of International Taxation” (1986) 3(2) Australian Tax Forum 217.

17 Para 76 of the OECD commentary on art 23A & 23B.

18 The interest withholding tax; dividend withholding tax; withholding tax on royalties;

withholding tax on foreign entertainers and sportspersons; withholding tax on the disposal of immovable property by non-resident sellers. See AW Oguttu "An Overview of South Africa's Withholding Tax Regime" TaxTalk (March/April 2014).

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gains realized on the sale of the shares from South African capital gains tax.

Treaties based on the OECD MTC provide in article 13(4) that the Contracting

State in which immovable property is situated may tax capital gains realised by

a resident of the other State on shares of companies that derive more than 50

per cent of their value from such immovable property. 19 However in Article

13(4) of the Dutch/South African DTA, only the Netherlands may impose tax on

the gains realized from the sale of shares in a South African company. In the

Netherlands, the gain on the sale of the shares should enjoy the protection

under the Dutch participation exemption, and it is possible to extract the gain

from the Dutch intermediate company without incurring withholding tax. The

OECD Final Report on Action 6 (see discussion in paragraph 4.2 of the Report

below) recommends that countries should ensure that there treaties have the

anti-abuse provision in article 13(4) of the OECD Model Convention. 20

Paragraph 28.5 of the Commentary on Article 13 provides that States may want

to consider extending the provision to cover not only gains from shares but also

gains from the alienation of interests in other entities, such as partnerships or

trusts, which would address one form of abuse.

The OECD noted that Article 13(4) will be amended to include such

wording. 21

In cases where assets are contributed to an entity shortly before the sale

of the shares or other interests in that entity in order to dilute the

proportion of the value of these shares or interests that is derived from

immovable property situated in one Contracting State. The OECD noted

that Article 13(4) also will be amended to refer to situations where shares

or similar interests derive their value primarily from immovable property

at any time during a certain period as opposed to at the time of the

alienation only. 22

These anti-abuse provisions can be adopted by South Africa if it signs

the envisaged multilateral instrument under Action 15, which will alleviate

the need to renegotiate all its double tax treaties to cover these changes.

Treaty shopping and dual resident entities

The concept of "dual residence" could be used to avoid the dividends

withholding tax (DWT) in South Africa. In terms of the current article 4(3) of the

OECD model convention, a dual resident entity is deemed to be resident where

its place of effective management (POEM) is located. If a company

incorporated in South Africa is effectively managed in the United Kingdom (UK),

it will be deemed to be a resident of the UK for purposes of the DTA between

South Africa and the UK. A UK resident parent company can thus avoid South

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African DWT on dividends derived from its South African subsidiary by

transferring the effective management of the subsidiary to the UK. The

subsidiary will then be treated as a UK tax resident which is not subject to DWT

in terms of section 64C of the ITA.

It should be noted though that the subsidiary will incur a CGT exit tax in

South Africa in terms of section 9H of the ITA and paragraph 12(2)(a) of

the Eighth Schedule to the ITA. The provision would for instance apply if

a company moves its place of effective management out of South Africa.

The OECD Final Report on Action 6 (see paragraph 4.3 of the Report

below) notes that the OECD will make changes to the OECD MTC to the

effect that treaties do not prevent the application of domestic “exit

taxes”.23

It should also be noted that the OECD recommends that the current

POEM rule in article 4(3) will be replaced with a case-by-case solution of

these cases.24 The competent authorities of the Contracting States shall

endeavour to determine by mutual agreement the Contracting State of

which such person shall be deemed to be a resident for the purposes of

the Convention, having regard to its POEM the place where it is

incorporated and any other relevant factors. In the absence of such

agreement, such person shall not be entitled to any treaty benefits. 25

South Africa can adopt this change in its tax treaties if it signs the

multilateral instrument envisaged under Action 15, which will alleviate the

need to renegotiate all double tax treaties.

Treaty shopping and permanent establishment concept

The permanent establishment concept (as set out in article 5) of most South

African DTAs does not include a building site or construction or assembly

project if the project does not exist for more than twelve months (in some DTAs,

e.g. the DTA with Israel, the period is limited to six months). A resident of those

contracting States will, therefore, not be subject to South African tax on building

or construction activities if the specific project does not last longer than twelve

months (six months for residents of Israel). A resident of the other contracting

state could split up the project into different parts, which are performed by

different legal entities, thus allowing the fuller project to be performed in South

Africa without incurring a tax liability in South Africa.

It should be noted that treaty abuse through splitting-up of contracts to

take advantage article 5 of the OECD Model Convention26 will be curtailed

by the OECD recommendation that the Principle Purpose Test rule that

will be added to the model convention in terms of the OECD Report on

23

OECD/G20 2015 Final Report on Action 6 in para 65-66. 24




,

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Action 7 (Preventing the Artificial Avoidance of Permanent Establishment

Status, 2015).27

Concerns about renegotiating all its tax treaties will be alleviated if South

Africa signs the envisaged multilateral instrument under Action 15.

Treaty shopping involving dividend transfer transactions

Taxpayers can get involved in dividend transfer transactions, whereby a

taxpayer entitled to the 15 per cent portfolio rate of Article 10(2)(b) may seek to

obtain the 5 per cent direct dividend rate of Article 10(2)(a) or the 0 per cent

rate that some bilateral conventions provide for dividends paid to pension

funds.28 The concern is that Article 10(2)(a) does not require that the company

receiving the dividends to have owned at least 25 per cent of the capital for a

relatively long time before the date of the distribution. This may encourage

abuse of this provision, for example, where a company with a holding of less

than 25 per cent has, shortly before the dividends become payable, increased

its holding primarily for the purpose of securing the benefits of the provision, or

where the qualifying holding was arranged primarily in order to obtain the

reduction. 29

The OECD concluded that in order to deal with such transactions, a

minimum shareholding period before the distribution of the profits will

be included in Article 10(2)(a).

Additional anti-abuse rules will also be included in Article 10 to deal

with cases where certain intermediary entities established in the State

of source are used to take advantage of the treaty provisions that

lower the source taxation of dividends.30


the envisaged multilateral instrument under Action 15, which will

alleviate the need to renegotiate all its double tax treaties to cover

these changes.

Issues Pertaining to migration of Companies

In the case of CSARS v Tradehold Ltd, 31 a South African company was

“migrated” to Luxembourg from a tax perspective. This had the effect of capital

gains which had accumulated in the company during the period that it was a

resident of South Africa being taxable only in Luxembourg. Luxembourg then

did not exercise its domestic tax law to tax any such gain. As a result of the

27


See paragraph 69 of the Commentary on Article 18 and also OECD/G20 2015 Final Report on Action 6 in para 34.



31 (132/11) [2012] ZASCA 61.

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decision in this case, South Africa’s domestic law was amended in order to

prevent such arrangements. Specifically, section 9H of the Income Tax Act

states that, inter alia, where a company that is a resident ceases to be a

resident, or a controlled foreign company ceases to be a controlled foreign

company, the company or controlled foreign company must be treated as

having disposed of its assets on the date immediately before the day on which

that company so ceased to be a resident or a controlled foreign company, for

an amount equal to the market value of its assets.

It is worth noting that the OECD Final Report on Action 6, the OECD

intends to make changes to the OECD MTC to the effect that treaties do

not prevent the application of domestic “exit taxes”. 32

Issues pertaining to dividend cessions

Shortly after the introduction of dividends tax in section 64D of the Income Tax

Act, various transactions were entered into by non-resident shareholders of

South African shares in order to mitigate the tax. In particular, non-resident

shareholders of listed South African shares in respect of which dividends were

to be declared transferred their shares to South African resident corporate

entities. The dividends were therefore declared and paid to the South African

resident corporate entities which claimed exemption from dividends tax on the

basis that, as set out in section 64F(1) of the Income Tax Act, the entities

constituted companies which were residents of South Africa.

o The provisions of section 64EB of the Act were therefore introduced in

August 2012 which adequately deal with such transactions since, inter

alia; they deem the “manufactured dividend” payments to constitute

dividends which are liable for dividends tax.

Base erosion resulting from exemption from tax for employment outside

the Republic

Section 10(1)(o)(ii) of the Income Tax Act, exempts from tax any remuneration

received or accrued by an employee by way of any salary, leave pay, wage,

overtime pay, bonus, gratuity, commission, fee, emolument, including an

amount referred to in paragraph(i) of the definition of gross income (fringe

benefits) subject to certain conditions. Section 10(1)(o) was implemented along

with the residence basis of taxation in 2001. It was supposed to be reviewed

after 3 years. More than ten years have passed without a review. The concern

about the provision is that there are many South Africans working abroad but

whose home is still South Africa, so the exemption takes away the right for

South Africa to tax on a residence basis. Because of the section 10(1)(o)

exemption, an SA resident individual working in a foreign tax free country will

32

OECD/G20 2015 Final Report on Action 6 in para 65-66.

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not pay tax anywhere in the world on his/her remuneration for services

rendered if he/she meets the 183 day (broken) and 60 day (continuous) outside

SA requirements per tax year. At present it is not clear as to how many

taxpayers are taking advantage of the exemption. SARS does not have reliable

statistics on this matter. In a double tax treaty context, article 15 of treaties

based on the OECD MTC deals with income from employment. It is

recommended that either:

The exemption should be withdrawn and a foreign tax rebate granted if

foreign tax is imposed on the basis that the ongoing income stream

should be taxable in RSA, even if the capital is invested abroad, or the

exemption is amended to only apply where the employee will be taxed

at a reasonable rate in the other country.

Base erosion that resulted from South Africa giving away its tax base

Some foreign jurisdictions, especially in Africa, are incorrectly claiming source

jurisdiction on services (especially management services) rendered abroad and

yet those services should be considered to be from a South African source.

These foreign jurisdictions are withholding taxes from amounts received by

South African residents in respect of services rendered in South Africa. The

withholding taxes are sometimes imposed even if a treaty that exists between

South Africa and the foreign country specifies otherwise, in that the treaties do

not have an article dealing with management fees or South African residents

have no permanent establishments in these countries. This results in double

taxation. In 2011, the section 6quin special foreign tax credit for service fees

was introduced to operate to offer relief from double taxation on cross-border

services for South African multinational companies that render services to their

foreign subsidiaries. National Treasury noted that section 6quin was intended to

be a temporal measure. However the section amounted to South Africa

effectively eroded its own tax base as it was obliged to give credit for taxes

levied in the paying country. In the 2015 Tax Laws Amendment Act the section

6quin special foreign tax credit was withdrawn with effect from 1 January 2016.

National Treasury’s reason for the change was that the special tax credit

regime was a departure from international tax rules and tax treaty principles in

that it indirectly subsidised countries that do not comply with the tax treaties.

South Africa was the only country in the world that provided for this kind of tax

concession. This provision effectively encouraged its treaty partners not to

abide by the terms of the tax treaty and it resulted in a significant compliance

burden on the South African Revenue Service. Some taxpayers also exploited

this relief by claiming it even for other income such as royalties and interest that

are not intended to be covered by this special tax credit.33 Mutual Agreement

Procedure (MAP) under tax treaties is the forum that ought to be used to solve

33

Explanatory Memorandum to the Taxation Laws Amendment Bill, 2015.

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such problems. There have been concerns that the withdrawal of section 6quin

could undermine South Africa as a location for headquarters and could see

banking, retail, IT and telecommunication companies relocating their service

centers elsewhere. The tax credit under section 6quin was reasoned to be one

of the reasons why such service companies based their headquarters in South

Africa.34 In order to mitigate against such concerns and any double taxation that

could be faced by South African taxpayers doing business with the rest of

Africa, section 6quat(1C) Income Tax Act has been amended to allow for a

deduction in respect of foreign taxes which are paid or proved to be payable

without taking into account the option of the mutual agreement procedure under

tax treaties. All tax treaty disputes should be resolved by competent authorities

through mutual agreement procedure available in the tax treaties. In terms of

SARS Interpretation Note 18, the phrase “proved to be payable” should be

interpreted as an "unconditional legal liability to pay the tax." The concern

though is whether the deduction method will offer the required taxpayers relief.

The word “paid" as used in the section could be interpreted as requiring an

"unconditional legal liability to pay the tax". If so, there would be no relief in

cases where tax is incorrectly withheld (e.g. contrary to treaty provisions).

To avoid such a situation, it is recommended that the wording in the

previous 6quin, should be reintroduced in section 6quat1(C) which gives

access to the section if tax was "levied" or "imposed" by a foreign

government.

It is submitted that the rationale behind the introduction of section 6quin

remains valid; in that it was intended to make South Africa an attractive

as a headquarter location. However this does not detract from the fact

that it resulted in the erosion of its own tax base.

South Africa’s need to develop a coherent policy in respect of treaty

negotiation and interpretation, especially with respect to its response to

Africa’s needs. SARS is encouraged to actively engage with the African

countries which are incorrectly applying the treaties with the objective of

reaching agreement on the correct interpretation and application of the

treaties. South African taxpayers should not be subjected to double

taxation simply because SARS is not able to enforce binding

international agreements with other countries.35

South African has a model tax treaty which informs its treaty

negotiations. This model treaty should be made publicly available and

any treaties that provide for the provision of taxing rights on technical

service fees should be renegotiated insofar as possible to bring them in

line with the model in this regard. 36

34

BusinessDay “MTN Warns Against Removing African Tax Incentive”. Available at http://www.bdlive.co.za/business/technology/2015/09/17/mtn-warns-against-removing-african-tax-incentive accessed 21 October 2015.

35 PWC “Comments on DTC BEPS First Interim Report” (30 March 2015) at 22.

36 PWC “Comments on DTC BEPS First Interim Report” (30 March 2015) at 22.

http://www.bdlive.co.za/business/technology/2015/09/17/mtn-warns-against-removing-african-tax-incentive


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As noted above, the Mutual Agreement Procedure (MAP) under tax

treaties is the forum that ought to be used to solve problems arising from

the improper application of the treaty, such as in this case, where treaty

services rendered by South African residents in treaty countries ought to

be taxed in South Africa but those countries still impose withholding

taxes on services rendered in these countries despite the fact that the

DTAs with these countries do not have an article dealing with

management fees or South African residents have no permanent

establishments in these countries. MAP has however not been effective

in Africa.

It is recommended that solving this problem, that is affecting intra-Africa

trade, will require organisations such as ATAF to play a significant role.

Treaty shopping that could be encouraged by South Africa’s Head quarter

company regime

South Africa has a Head Quarter Company (HQC) regime under section 9I and

of the ITA. The objective of the HQC regime is to promote the use of South

Africa as the base for holding international investments. Thus headquarter

companies are, for example, not subject to CFC rules, transfer pricing and thin

capitalisation rules. Dividends declared by a HQC are exempt from dividends

withholding tax. HQCs are exempt from the interest withholding tax. Royalties

paid by a HQC are not subject to the withholding tax on royalties. A HQC must

also disregard any capital gain or capital loss in respect of the disposal of any

equity share in any foreign company, provided it held at least 10% of the equity

shares and voting rights in that foreign company. The HQC will thus be subject

to tax by virtue of its incorporation in South Africa, but the various exemptions

from withholding taxes and the transfer pricing rules should have the impact

that the HQC would not effectively be subject to any tax. Since the HQC will be

“liable to tax by virtue of its incorporation”, it will generally be entitled to the

benefits of the South African DTA network,37 it could encourage treaty shopping

by non-residents.

The question arises whether a court could conceivably condemn a treaty

shopping scheme by a non-resident to access a DTA with South Africa if

the South African Legislator has effectively sanctioned treaty shopping

by non-residents to access South African DTAs with other countries.

37

Article 1 of the UK/South Africa DTA, which is the typical requirement to qualify as a resident of South Africa for DTA purposes.

14

DTC REPORT ON ACTION 6: PREVENT TREATY ABUSE

Table of Contents

1 INTRODUCTION ....................................................................................... 16

2 PREVIOUS MEASURES RECOMMENDED IN THE OECD MODEL TAX

COVENTION TO CURB TREATY SHOPPING ......................................... 17

2.1 DOMESTIC ANTI-AVOIDANCE PROVISIONS ................................... 17

2.2 SPECIFIC TREATY PROVISIONS ...................................................... 17

3 INTERNATIONAL APPROACHES ........................................................... 20

3.1 THE CANADIAN APPROACH ............................................................. 20

3.2 THE UK APPROACH ........................................................................... 26

3.3 THE GERMAN APPROACH ................................................................ 29

3.4 THE US APPROACH ........................................................................... 30

4 THE OECD BEPS PROJECT .................................................................... 39

4.1 OECD RECOMMENDATIONS REGARDING THE DESIGN OF

DOMESTIC RULES TO PREVENT THE GRANTING OF TREATY

BENEFITS IN INAPPROPRIATE CIRCUMSTANCES ......................... 40

4.2 OECD RECOMMENDATIONS REGARDING OTHER SITUATIONS

WHERE A PERSON SEEKS TO CIRCUMVENT TREATY LIMITATIONS

42

4.3 OECD RECOMMENDATIONS IN CASES WHERE A PERSON TRIES

TO ABUSE THE PROVISIONS OF DOMESTIC TAX LAW USING

TREATY BENEFITS ............................................................................ 46

4.4 OECD CLARIFICATION THAT TAX TREATIES ARE NOT INTENDED

TO BE USED TO GENERATE DOUBLE NON-TAXATION .................. 50

4.5 OECD RECOMMENDATIONS ON TAX POLICY CONSIDERATIONS

THAT, IN GENERAL, COUNTRIES SHOULD CONSIDER BEFORE

DECIDING TO ENTER INTO A TAX TREATY WITH ANOTHER

COUNTRY OR TO TERMINATE ONE ................................................. 51

5 PREVENTING TREATY SHOPPING IN SOUTH AFRICA ........................ 53

5.1 THE STATUS OF DOUBLE TAX TREATIES IN SOUTH AFRICA ........ 53

15

5.2 TREATY SHOPPING IN SOUTH AFRICA ........................................... 59

5.2.1 TREATY SHOPPING: REDUCING SOURCE TAX ON DIVIDENDS,

ROYALTIES AND INTEREST WITHHOLDING TAXES ................ 59

5.2.2 TREATY SHOPPING: ACCESSING CAPITAL GAINS BENEFITS

...................................................................................................... 61

5.2.3 SCHEMES TO CIRCUMVENT DTA LIMITATIONS ...................... 63

5.2.4 TREATY SHOPPING IN SOUTH AFRICA’S PREVIOUS TREATY

WITH MAURITIUS ........................................................................ 66

5.2.5 TREATY SHOPPING: SOUTH AFRICA’S TREATIES

ENCOURAGING DOUBLE NON-TAXATION ............................... 78

5.2.6 TREATIES WITH TAX SPARING PROVISIONS .......................... 79

5.2.7 ISSUES PERTAINING TO MIGRATION OF COMPANIES .......... 84

5.2.8 ISSUES PERTAINING TO DIVIDEND CESSIONS ........................ 84

5.2.9 BASE EROSION RESULTING FROM EXEMPTION FROM TAX

FOR EMPLOYMENT OUTSIDE THE REPUBLIC ......................... 85

5.2.10 BASE EROSION RESULTING FROM SOUTH AFRICA GIVING

AWAY ITS TAX BASE .................................................................. 86

5.2.11 TREATY SHOPPING THAT COULD BE ENCOURAGED BY

SOUTH AFRICA’S HEAD QUARTER REGIME ............................ 90

6 CURRENT MEASURES TO CURB TREATY SHOPPING IN SOUTH

AFRICA ..................................................................................................... 92

6.1 USE OF DOMESTIC PROVISIONS ...................................................... 92

6.2 SPECIFIC TREATY PROVISIONS ...................................................... 96

6.2.1 THE BENEFICIAL OWNERSHIP PROVISION ................................. 96

6.2.2 THE LIMITATION OF BENEFITS PROVISION ........................... 100

7 RECOMMENDATIONS TO ADDRESS TREATY SHOPPING IN SOUTH

AFRICA IN LIGHT OF 2015 FINAL REPORT ON ACTION 6 ................. 101

16

1 INTRODUCTION

In terms of Article 1 of the OECD Model Tax Convention (OECD MTC), the first

requirement that must be met by a person who seeks to obtain benefits under a

double tax treaty is that the person must be “a resident of a Contracting State”,

as defined in Article 4 of the OECD MTC. There are a number of treaty abuse

arrangements through which a person who is not a resident of a Contracting

State may attempt to obtain benefits that a tax treaty grants to residents of the

contracting States. These arrangements are generally referred to as “treaty

shopping”; a term that describes the use of double tax treaties by the residents

of a non-treaty country in order to obtain treaty benefits that are not supposed

to be available to them.38 This is mainly done by interposing or organising a

“conduit company”39 in one of the contracting states so as to shift profits out of

the non-treaty states.40

Similarly when a conduit company is set up in a third country, this can result in

loss of revenue for the signatories to a treaty .41

Treaty shopping is undesirable because it frustrates the spirit of the treaty.

When treaties are concluded, the assumption is that a certain amount of

income will accrue to both countries involved in the treaty and would, without

the treaty, be taxed in both countries. The anticipated capital flows are distorted

if the treaty is used by third country residents. When unintended beneficiaries

are free to choose the location of their businesses, then treaties designed to

eliminate double taxation may end up being used to eliminate taxation

altogether.42 Treaty shopping can result in a bilateral treaty functioning largely

* DTC BEPS Sub-committee: Prof Annet Wanyana Oguttu, Chair DTC BEPS

Subcommittee (University of South Africa - LLD in Tax Law; LLM with Specialisation in Tax Law, LLB, H Dip in International Tax Law); Prof Thabo Legwaila, DTC BEPS Sub-Committee member (University of Johannesburg - LLD, ) and Ms Deborah Tickle, DTC BEPS Sub-Committee member (Director International and Corporate Tax Managing Partner KPMG).

38 H Becker & FJ Wurm Treaty Shopping: An Emerging Tax Issue and its Present Status in

Various Countries (1988) at 1; S van Weeghel The Improper Use of Tax Treaties with Particular Reference to the Netherlands and The United States (1998) at 119.

39 Defined below.

40 After setting up the conduit company structure, other “stepping stone” strategies can also

be applied to shift income from the contracting countries. This could be done by changing the nature of the income to appear as tax deductible expenses such as commission of service fees. See FJ Wurm Treaty Shopping in the 1992 OECD Model Convention Intertax (1992) at 658; S M Haug “The United States Policy of Stringent Anti-treaty shopping Provisions: A Comparative Analysis” (1996) 29 Vanderbilt Journal of Trans-national law at 196; E Tomsett Tax planning for Multinational companies (1989) at 149.

41 OECD Issues in International Taxation No. 1 International Tax Avoidance and Evasion

(1987) at 20; A Ginsberg International Tax Havens 2nd ed (1997) at 5-6; P Roper & J Ware Offshore Pitfalls (2000)at 5.

42 Weeghel at 121 notes that treaty shopping results in international income being

exempt from taxation altogether or being subject to inadequate taxation in a way unintended by the contracting states.

17

as a “treaty with the world”, and this can often result in loss of revenue for the

contracting states. 43

2 PREVIOUS MEASURES RECOMMENDED IN THE OECD MODEL TAX

COVENTION TO CURB TREATY SHOPPING

The 2014 version OECD MTC (yet to be revised in line with the OECD BEPS

recommendations) provides for two main measures to prevent treaty abuse.

These are: the use of domestic anti-avoidance provisions and the use of

specific treaty provisions.

2.1 DOMESTIC ANTI-AVOIDANCE PROVISIONS

Paragraph 7.1 of the OECD Commentary on Article 1 of the OECD MTC

Convention provides that where taxpayers are tempted to abuse the tax laws of

a State by exploiting the differences between various countries’ laws, such

attempts may be countered by jurisprudential rules that are part of the domestic

law of the state concerned. In other words, the onus is placed on countries to

adopt domestic anti-avoidance legislation to prevent the exploitation of their tax

base and then to preserve the application of these rules in their treaties. The

current Commentary on Article 1 states in paragraph 22 that, when base

companies44 are used to abuse tax treaties, domestic anti-avoidance rules such

as “substance over form”, 45 “economic substance” and other general anti-

avoidance rules can be used to prevent the abuse of tax treaties.46

2.2 SPECIFIC TREATY PROVISIONS

The Commentary on Article 1 of the OECD MTC also suggests the following

examples of specific clauses that can be inserted in tax treaties to curb the

different forms and cases of conduit company treaty shopping.

43

R Rohatgi Basic International Taxation (2002) at 363; Haug at 218; Weeghel at 121. 44

A base company can be defined as a company that acts as a holder of the legal title that belongs to the parent company, which may be registered outside the country where the base company is registered. See AW Oguttu International Tax Law: Offshore Tax Avoidance in South Africa (2015) at 127.

45 Ware and Roper at 77 where the ‘substance over form’ doctrine is described as a

doctrine which permits the tax authorities to ignore the legal form of a tax arrangement and look at the actual substance of the relevant transaction.

46 This position seems to be based on the 1987 OECD Report entitled ‘Double Taxation

Conventions and the Use of Base Companies’ which states in par 38 that anti-abuse rules or rules on ‘substance over form’ can be used to conclude that a base company is not the beneficial owner of an item of income.

18

The “look through” approach: In terms of this approach treaty benefits should

be disallowed for a company not owned, directly or indirectly, by residents of

the State of which the company is a resident.47

The subject-to-tax provision: In terms of this approach, treaty benefits in the

state of source can be granted only if the income in question is subject to tax in

the state of residence.48

Exclusion provisions: This approach denies treaty benefits where specific types

of companies enjoy tax privileges in their state of residence that facilitate

conduit arrangements and harmful tax practices.49

Provisions that apply to subsequently enacted regimes: Paragraph 21.5 of the

Commentary suggests a provision that can be inserted in treaties to protect a

country against preferential regimes adopted by its treaty partner after the

treaty has been signed. Such a provision would apply to both existing and

subsequently enacted regimes.50

The “limitation of benefits” provision: This provision is aimed at preventing

persons who are not residents of the contracting states from accessing the

benefits of a treaty through the use of an entity that would qualify as a resident

of one of the States.51 The gist of such a provision is to the effect that residents

of a contracting state who derive income from the other contracting state shall

be entitled to all benefits of the treaty with respect to an item of income derived

from the other state only if the resident is actively carrying on business in the

first mentioned state, and the income derived from the other contracting state is

derived in connection with, or is incidental to, that business, and that resident

satisfies the other conditions of the treaty for access to such benefits.52

The “beneficial ownership” clause: Paragraph 10 of the Commentary suggests

the use of a “beneficial ownership” clause as one of the anti-abuse provisions

that can be used to deal with source taxation of specific types of income set out

in articles 10, 11 and 12 of the OECD MTC. The concept of “beneficial owner”

was introduced in the OECD MTC in 1977 in order to deal with simple treaty

shopping situations where income is paid to an intermediary resident of a treaty

country who is not treated as the owner of that income for tax purposes (such

47

Para 13 of the commentary on Article 1 of the OECD Model Convention. See also AJM Jiménez ‘Domestic Anti-Abuse Rules and Double Taxation Treaties: A Spanish Perspective – Part 1’ (Nov. 2002) Bulletin for International Fiscal Documentation at 21.

48 Para 15 of the commentary on article 1 of the OECD Model.’

49 BJ Arnold The Taxation of Controlled Foreign Corporations: An International Comparison

(1986) at 256. 50

Jiménez ‘at 22.

51 Para 20 of the commentary on article 1 of the OECD Model Convention.

52

Ibid.

19

as an agent or nominee). This resulted in the addition of a section on “Improper

Use of the Convention” to the Commentary on Article 1. This section was

expanded in succeeding years, after the OECD released reports such as the

1986 report on Double Taxation and the Use of Base companies and the 1992

Report on Double Taxation and the Use of Conduit Companies.

The term “beneficial ownership” is, however, not defined in the OECD MTC or

its Commentary.53 Although article 3(2) of the OECD MTC permits countries to

apply the domestic meaning of a term that is not fully defined in the OECD

MTC, with regard to the beneficial ownership concept, the OECD recommends

that the definition should carry an international meaning that would be

understood and used by all countries that adopt the OECD MTC.54 There is

however no clear international meaning of the term, and many countries,

including South Africa, do not have a definition in domestic legislation.

The OECD MTC does, however, provide some clues to the meaning of the

term. In terms of the OECD MTC, a nominee or agent who is a treaty country

resident may not claim benefits if the person who has all the economic interest

in, and all the control over, property (the beneficial owner) is not also a resident.

To further clarify the meaning of the term, in 2003 the OECD released a Report

on Restricting the Entitlement to Treaty Benefits which lead to amendments in

the OECD MTC to further clarify that a conduit company cannot be regarded as

a beneficial owner if, through the formal owner, it has, as a practical matter,

very narrow powers which render it, in relation to the income concerned, a mere

fiduciary or administrator acting on account of the interested parties (such as

the shareholders of the conduit company).55

In October 2012, 56 the OECD issued revised proposals to amend the

Commentaries on articles 10, 11 and 12 to provide that beneficial ownership

has a treaty meaning independent of domestic law57 and that it means “the right

to use and enjoy” the amount “unconstrained by a contractual or legal obligation

to pass on the payment received to another person.” However the effectiveness

of the beneficial ownership provision in curbing treaty shopping is now

questionable in light of certain international cases such as the decisions in

Canadian cases of of Velcro Canada Inc. v The Queen58 and Prevost Car Inc. v

53

International Fiscal Association The OECD Model Convention – 1998 and Beyond; The Concept of Beneficial Ownership in Tax Treaties (2000) at 15.

54 L Oliver & M Honiball International Tax: A South African Perspective (2011) at 46; The

International Fiscal Association’s 2000 Report on the OECD Concept of Beneficial Ownership in Tax Treaties at 20.

55 OECD “Report on the Use of Base Companies” (1987) in par 14(b).

56 OECD “Revised Proposals concerning the Meaning of “Beneficial Owner” in Articles 10,

11, and 12” (19 October (2012). 57

Proposed paragraph 12.1 of the Commentary on Article 10, paragraph 9.1 of the Commentary on Article 11, and paragraph 4 of the Commentary on Article 12.

58 2012 TCC 57.

20

Her Majesty the Queen 59 (discussed under the international approached

below). As a result of cases such as the above additional work by the OECD,

on the clarification of the “beneficial ownership” concept, resulted in changes to

the Commentary on articles 10, 11 and 12 of the 2014 version of the OECD

MTC, which acknowledged the limits of using that concept as a tool to address

various treaty-shopping situations. 60

Paragraph 12.5 of the Commentary on Article 10 provides that: “whilst the

concept of “beneficial ownership” deals with some forms of tax avoidance (i.e.

those involving the interposition of a recipient who is obliged to pass on the

dividend to someone else), it does not deal with other cases of treaty shopping

and must not, therefore, be considered as restricting in any way the application

of other approaches to addressing such cases.”

3 INTERNATIONAL APPROACHES

3.1 THE CANADIAN APPROACH

The Canadian tax authorities have three distinct measures available to combat

tax avoidance, which include specific legislative anti-avoidance provisions, a

general legislative anti-avoidance rule (the GAAR), and judicial anti-avoidance

doctrines, i.e. the sham doctrine, the doctrine of legally ineffective transactions

and the substance versus form doctrine.61 In the Canadian Federal Court of

Appeal case of Paul Antle and Renee Marquis-Antle Spousal Trust v The

Queen,62 the Minister of National Revenue relied on specific legislative anti-

avoidance provisions, the judicial doctrines of sham and legally ineffective

transactions, as well as on the GAAR, to challenge the tax treatment claimed by

a taxpayer with respect to certain international transactions.

Before the amendment of the Canadian GAAR in 2005 (retroactively to the date

of inception in 1988), there was uncertainty whether the GAAR could apply to

transactions that resulted in a misuse or abuse of a DTA. The Canadian

government ended any uncertainty by amending the GAAR to include in the

definition of “tax benefit” those benefits derived from a DTA, and by providing

that the GAAR applied to transactions that misuse or abuse a DTA.63

59

2008 TCC 231. 60

OECD “Tax Conventions and Related Questions: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances” (17-18 September 2013) para 8.

61 Canadian Country Report in the 2010 IFA Report, Volume 1 at 172.

62 2009 TCC 465 (TCC), appeal filed to the Federal Court of Appeal (FCA), A-428-09.

63 IFA Report at 175.

21

The Supreme Court of Canada established the methodology to be followed to

determine whether the GAAR can be applied to deny a tax benefit. 64 The

following three requirements must be established: (a) a tax benefit; (b) an

avoidance transaction; and (c) abusive tax avoidance. The burden is on the

taxpayer to prove that there was no tax benefit or no avoidance transaction

whilst the Canadian tax authorities must show that there was abusive tax

avoidance. The abuse analysis is conducted in two stages. Under the first

stage, the court must conduct a unified textual, contextual and purposive (TCP)

analysis of the provisions conferring the benefit, in order to determine why

these provisions were put in place and why the benefit was conferred. With

respect to DTAs, this means that the Court should look at (a) the text of the

provisions; (b) their context, which is likely to include other DTA provisions, the

preamble, the annexes, other treaties and the OECD Commentary on the

OECD Model DTA; and (c) the purpose of the provisions as well as the purpose

of the treaty. Under the second stage of the abuse analysis, the court should

determine whether the avoidance transactions respect or defeat the object,

spirit or purpose of the provisions in issue.

The approach, by the courts in Canada, was analysed by Nathalie Goyette in

her thesis65 and also in her subsequent paper in the Canadian Jaw Journal.66

She considers whether the Canadian general anti-abuse rules could be applied

to counter DTA abuse. Her 1999 thesis concluded that the preamble to

Canadian treaties, which stipulates that the purpose of the DTA is to prevent

tax evasion, does not constitute a general anti-abuse rule applicable to DTAs

for three reasons. First, tax evasion is not synonymous with tax avoidance, and

in cases of abuse, the issue is avoidance. Second, although the preamble

refers to the prevention of tax evasion, DTAs generally do not include

provisions to deal with evasion. Finally, the “domestic tax benefit provision”

contained in most Canadian DTAs (according to which the provisions of the

DTA do not restrict in any way the deductions, credits, exemptions, exclusions,

or other allowances available under domestic tax law), coupled with the

principle that DTAs do not levy taxes, supports the argument that the preamble

to DTAs does not include a general anti-abuse rule.67

However, she points out that in some French-speaking countries, the word

“évasion” extends to avoidance transactions, i.e. the word “évasion” found in

paragraph 7 of the OECD Commentary on article 1 of the OECD Model DTA

probably extends to “évitement” (“avoidance”), as is confirmed by the English

64

Canada Trustco Mortgage Co. v. Canada, [2005] 2 S.C.R. 601, 2005 SCC 54, in paras 17 and 66; Mathew v Canada [2005] 2 SCR 643 in para 31.

65 Nathalie Goyette “Countering Tax Treaty Abuses: A Canadian Perspective on an

International Issue: The Tax Professional Series” (Toronto: Canadian Tax Foundation, 1999).

66 Goyette at 766.

67 Ibid.

22

version. Therefore, she concludes that there are now grounds to argue that

one of the purposes of DTAs is the prevention of avoidance.68

She refers to the decision of the Supreme Court of Canada in Crown Forest

Industries v Canada,69 where the Court was asked to determine whether a

corporation incorporated in the Bahamas, Norsk, was resident in the United

States for the purposes of the application of the Canada-US treaty. If such were

the case, Norsk could benefit from a reduced rate of withholding tax in respect

of rental income that it earned in Canada. Iacobucci J made the following

comments in the course of his analysis:70 “It seems to me that both Norsk and the respondent are seeking to minimize their tax

liability by picking and choosing the international tax regimes most immediately beneficial

to them. Although there is nothing improper with such behaviour, I certainly believe that it

is not to be encouraged or promoted by judicial interpretation of existing agreements.”

Iacobucci J went on to state that:

“adopting the interpretation of the word “resident” proposed by Norsk would mean that a

corporation that was not subject to any US tax could nonetheless benefit from the

reduction in Canadian withholding tax provided for in the Canada-US treaty.”

This observation led him to comment:71

“Treaty shopping” might be encouraged in which enterprises could route their income

through particular states in order to avail themselves of benefits that were designed to be

given only to residents of the contracting states. This result would be patently contrary to

the basis on which Canada ceded its jurisdiction to tax as the source country, namely

that the US as the resident country would tax the income”.

Goyette points out that the numerous other decisions that have referred to the

modern and broad interpretive rule for DTAs proposed by the Supreme Court in

Crown Forest seem to confirm that the latter judgment has had a distinct impact

on the manner in which the courts approach Canadian DTA.72 Furthermore, she

notes that recent literature indicates that the presumption against treaty

shopping articulated in Crown Forest may be a more useful weapon for

Canadian tax authorities than GAAR. She observes that the question that

remains is the appropriate scope of the anti-treaty-shopping presumption set

out in Crown Forest. She points out that the Supreme Court stated that to allow

treaty shopping would be contrary to the basis on which Canada ceded its

jurisdiction to tax as the source country—namely, that the United States, as the

country of residence, would tax the income.

68

Ibid at 793. 69

[1995] 2 SCR 802. 70

Goyette at 773. 71

Ibid. 72

Ibid at 774.

23

However, even if a state is allocated a right to tax under a DTA, nothing

requires it to exercise that right. Consequently, one might question the

soundness of the Supreme Court’s reasoning. She expressed the view that it

seems preferable to interpret the Court’s pronouncement as simply stating that

treaty shopping is contrary to the basis on which Canada agreed to restrict its

jurisdiction to tax, namely, that the taxpayer who receives the income in

question is a resident of the United States. Since Norsk was not a US resident,

there was no reason for Canada to limit its taxing power.73

Goyette observes 74 that, since 1999, the Federal Court Trial Division has

rendered a decision in Chua v. Minister of National Revenue.75 In that decision,

the court stated that DTAs have two primary objectives: to avoid double

taxation and to permit governments to collect amounts due to them by dividing

these amounts between them and by combating tax avoidance and evasion.76

She points out that this is the second time that the Federal Court has declared

that one of the purposes of DTAs is to combat tax avoidance, which may be the

beginning of a trend toward clear interpretation in this regard. She concludes

that if the courts were to uphold this trend, they could find it easier to rule that

the interpretation of DTAs on the basis of their object or purpose authorizes the

application of a domestic anti-abuse rule such as GAAR in cases of DTA

abuse; moreover, it is possible that the recent revisions to the OECD

Commentary may persuade the courts to consider that one purpose of DTAs is

to prevent tax avoidance.77

Goyette considers a “borderline” case is in fact a variation of the classic

situation of “treaty shopping” through which a Dutch company is interposed in

order to benefit from the DTA between Canada and the Netherlands78. In this

example, a Bahamian company wanted to loan money to a Canadian company,

but a direct loan would have given rise to part XIII tax of 25 percent on the

interest. Consequently, the Bahamian company incorporated a company in the

Netherlands (Dutchco), which loaned money to the Canadian company. The

transaction was structured so that very little tax would be paid in the

Netherlands and withholding tax would be avoided when the money was

returned to the Bahamas.

In her 1999 thesis, Goyette concluded that the search for concordance meant

that GAAR could not be invoked in this situation.79 Her conclusion was based

primarily on the following factors:

73

Ibid at 774. 74

Ibid at 793. 75

[2000] 4 CTC 159 (FCTD). 76

Ibid at 179. 77

Goyette at 793. 78

Ibid at 802. 79

Ibid.

24

the Netherlands considers that Dutchco is resident in that country

and is entitled to the benefits of the treaty with Canada;

the Netherlands treats the amounts received by Dutchco as taxable

interest, and thus Canada also must consider that the Canadian

company paid interest to Dutchco; and

the objective intention of the contracting states is that domestic anti-

abuse rules are not applicable to abuses of the Canada-Netherlands

treaty.

Goyette points out80 that a re-examination of this scenario, or a more flexible

and objective application of the search for symmetry of treatment, calls for a

different conclusion. First, it should be noted that in a number of situations

similar to that of Dutchco, an argument can be made that a company like

Dutchco is not the beneficial owner of the interest; and, on the basis of the

facts, this argument could satisfy a court that there is no ground for granting the

reduction in withholding tax provided for by the DTA. Article 11(2) of the

Canada-Netherlands DTA provides for a reduction in the rate of withholding tax

imposed by the source state (in this case Canada), but only to the extent that

the person who claims this reduced rate is the “beneficial owner” of the interest.

Goyette observes81 that the revised OECD Commentary on articles 10, 11, and

12 of the OECD Model DTA points out that the term “beneficial owner” is not to

be used in a narrow technical sense, rather it should be understood in its

context and in light of the object and purposes of the Model DTA, including

avoiding double taxation and the prevention of fiscal evasion and avoidance.

She points out82 that the revised OECD Commentary adds that it would be

contrary to the purpose and the object of the DTA for the source state (such as

Canada in the Dutchco example) to grant a reduction of tax to a resident of a

contracting state who acts as an agent, a nominee, or a simple intermediary for

another person who, in fact, receives the benefit of the income in question. It

follows that if the facts demonstrate that Dutchco is merely an agent or conduit,

or that it cannot profit freely from the interest paid by the Canadian company, a

court will likely conclude that Dutchco is not the beneficial owner of the interest

and is therefore not entitled to the reduced rate of withholding tax provided for

by the Canada-Netherlands DTA.

The Canadian Federal Court of Appeal considered the “beneficial ownership”

requirement in the 2006 case reported as Prévost Car Inc v Her Majesty the

Queen.83 In this case, a Swedish resident and a UK resident held their shares

in Prévost Car Inc, a Canadian company, via a Dutch holding company

80

Goyette at 793. 81

Goyette at 803. 82

Ibid. 83

2006 DTL 330.

25

(HoldCo). Under the applicable DTAs, a 10% withholding tax is imposed on

dividends paid to a Swedish shareholder and 15% on dividends paid to a

shareholder in the UK, whilst the Netherlands-Canada DTA reduces the

dividend withholding tax to 5%. The Court had to decide whether, for purposes

of claiming treaty relief, the Dutch holding company (as opposed to its

shareholders) was the beneficial owner of dividends received from its wholly

owned subsidiary. The court, in finding that the Dutch holding company

(DutchCo) was the beneficial owner of the dividends, held that: “The beneficial owner of the dividends is the person who receives the dividends for his or

her own use and enjoyment and assumes the risk and control of the dividend he or she

received.”

“When corporate entities are concerned, one does not pierce the corporate veil unless

the corporation is a conduit for another person and has absolutely no discretion as to the

use or application of funds put through it as conduit or has agreed to act on someone

else’s behalf pursuant to that person’s instructions without any right to do other than what

that person instructs it, for example, a stockbroker who is the registered owner of the

shares it holds for clients.”

In Velcro Canada Inc v Her Majesty The Queen (judgment delivered on 24

February 2012) 84 the Court again considered the beneficial ownership

requirement for DTA relief. In this case, Velcro Industries BV (VIBV), a Dutch

company which migrated to the Netherlands Antilles during 1995, owned

certain intellectual property. At the time, VIBV made the intellectual property

available to Velcro Canada Inc (“VCI”) in terms of a licence agreement. Two

days after its migration to the Netherlands Antilles, VIBV assigned the licence

agreement to Velcro Holdings BV (“VHBV”), a company resident in the

Netherlands. In terms of the assignment agreement, the ownership of the

intellectual property remained with VIBV and VHBV:

was assigned the right to grant licences for VIBV’s intellectual

property to VCI and to collect royalty payments from VCI as payment

for the licences;

was obliged to enforce the terms of the licence agreement and to

take any steps necessary should VCI breach the terms of the

contract; and

was obliged to pay 90%85 of the royalties so received to VIBV within

30 days of receiving royalty payments from VCI.

In terms of Canadian law, a withholding tax of 25% applies to royalties paid to

non-residents. However, until 1999, the rate was reduced to 10% in terms of

the Netherlands-Canada DTA, whereafter it was reduced even further to 0%.

84

2012 TCC 57. 85

This secured the arm’s length margin required by the Dutch tax authorities.

26

The Court followed the approach of the Court in the Prévost-case by holding

that, when considering the beneficial owner of income, “one must determine

who has received the payments for his/her own use and enjoyment and

assumed the risk and control of the payment he/she received.” The Court held

that the attributes of beneficial ownership are “possession”, “use”, “risk” and

“control”. The Court considered the dictionary meaning of each of these

concepts (as defined in Black’s Law Dictionary) and applied it to the facts. It

held that:

VHBV had possession of the royalties as it had exclusive possession

of the funds upon receipt, the funds were comingled with VHBV’s

“general funds” and there was no automatic flow-through of royalties

to VIBV;

VHBV used the funds for its own benefit as there were no restrictions

on the use of the funds. The fact that it was contractually obliged to

pay an amount equal to 90% of the royalties to VIBV, did not impact

on the fact that it had the use of the funds received from VCI;

The royalties received were the assets of VHBV and available to

creditors of VHBV, with no priority given to VIBV. The risk thus

remained with VHBV;

VHBV did have control over the funds as it received it for its own

account, comingled the funds with its other funds, etc.

On behalf of the Canadian tax authority, it was argued that VHBV was a mere

agent for VIBV, or acted as nominee or conduit. However, the Court held that it

would only “take the draconian step of piercing the corporate veil” should the

recipient of the funds have “absolutely no discretion” regarding the use and

application of the funds. The Court found that even though VHBV’s discretion

may be limited, it still had a discretion. The Court thus concluded that VHBV

was the beneficial owner of the royalties and accordingly entitled to the benefit

of the Netherlands-Canada DTA.

3.2 THE UK APPROACH

The UK country report (UK IFA Report) in the IFA Report 201086 surmises that

DTAs may well stand in conflict with UK domestic anti-avoidance provisions,

including in ways which have not yet been fully tested before the courts. The

UK IFA Report expresses the view that the conflict may be countered through

further domestic provisions intended to re-establish the domestic law position,

some involving a more overt DTA override than others. (Very occasionally,

however, the DTA will itself contain an anti-avoidance provision which would

not otherwise be reflected in UK domestic law and the domestic law provides

that no better result may be obtained.)

86

IFA Report at 805.

27

Judicial approaches to tax avoidance have been more restrained in construing

DTAs than in construing domestic legislation, given in part the need for uniform

construction of DTAs. This has further fuelled the difficult relationship between

domestic anti-avoidance provisions and DTAs. The UK IFA Report concludes

that the statement at paragraph 22(1) of the OECD Commentary on article 1, to

the effect that there will be no conflict between anti-avoidance provisions and

DTAs, is therefore too bald a statement as far as UK law and practice is

concerned87.

The UK IFA Report observes88 that the title of most of the UK DTAs refers to

the avoidance of double taxation and the prevention of fiscal evasion, but not to

the prevention of avoidance. Although the French version of the OECD Model

carries equal weight, in the UK domestic context evasion means taking unlawful

steps to escape a tax liability whereas avoidance means taking lawful but

sometimes ineffective steps to escape a liability, where the effectiveness will

depend on the application and interpretation of the relevant taxing provisions.

Originally the emphasis was clearly on addressing juridical double taxation89 as

well as the prevention of evasion by providing for the exchange of information.

However, as avoidance became more of a concern specific provisions have

been introduced incrementally in line with international practice.

In the absence of a GAAR in the UK Tax Act, the UK IFA Report outlined the

application of specific anti-tax avoidance provisions of the UK Tax Act to

counter DTA abuse.90 Of particular interest was the application of the UK CFC

rules in cases where a UK resident set up a foreign intermediary company in a

country which has a DTA with the UK, which protects the income of such

intermediary from UK tax.

This scenario was considered by the UK Court of Appeal in Bricom Holdings

Ltd v. CIR.91 The case dealt with the application of the UK prevailing CFC rules

in respect of UK source interest received by a Netherlands subsidiary of a UK

parent. The interest received by its Netherlands subsidiary was apportioned

under the UK’s CFC rules to the UK parent. The Court had to consider whether

the CFC rules could apply in the context of article 7 of the UK/Netherlands DTA,

87

Ibid. 88

Ibid at 818. 89

The term “juridical double taxation” refers to the imposition of comparable taxes in two (or more) countries on the same taxpayer in respect of the same subject matter and for identical periods. “Economic double taxation” arises when the same economic transaction, item, or income is taxed in two or more jurisdictions during the same period, but in the hands of different taxpayers. See AW Oguttu International Tax Law: Offshore Tax Avoidance in South Africa (2015) at 159.

90 Ibid at 807.

91 [1997] EWCA Civ 2193.

28

which prohibited the UK from taxing income derived by a Netherlands company

unless the company operated in the UK through a permanent establishment

and such interest was attributable to such a base.

The Court held that the CFC rules did not function to tax the interest income of

the Netherlands subsidiary, but an amount equal to the net income of the CFC

which is allocated to the resident of the UK, i.e. the Court found that there is no

conflict between the CFC rules and the DTA provisions. The amount calculated

under the CFC rules is merely a notional profit amount and is no longer interest

income as contemplated in the DTA. 92 However, the Court appeared to

acknowledge that the UK would have otherwise contravened its DTA

obligations.

In Indofood International Finance Ltd v J P Morgan Chase Bank93, a case heard

by the Court of Appeal in the UK during 2006, the Court considered the

situation where an Indonesian company wished to raise funding by issuing loan

notes on the international market. However, should the Indonesian company

have raised the funding directly, interest payable to note holders would have

been subject to a 20% Indonesian withholding tax on interest. The Indonesian

company thus incorporated a Mauritian company (“the Issuer”) which issued

loan notes to note holders. The Issuer and the Indonesian company (“the

Parent Guarantor”) then entered into a loan agreement which complied with the

relevant terms of the DTA between Mauritius and Indonesia, which reduced the

Indonesian withholding tax on the interest from 20% to 10%.

When it became known that the DTA would be renegotiated and that the

interest withholding rate would not be reduced in terms of the renegotiated

DTA, it was suggested that a Dutch company (“Newco”) should be interposed

between the Issuer and the Parent Guarantor. Newco would have no role other

than to receive the interest from the Parent Guarantor and to pay it to a paying

agent (“the Principal Paying Agent”) for the benefit of the note holders. In fact,

Newco would be obliged, in terms of the respective loan agreements, to on-pay

funds received from the Parent Guarantor to the Principal Paying Agent, and

would be precluded from “finding the money from any other source”.

In terms of the Netherlands-Indonesia DTA, should Newco be the beneficial

owner of the interest, the interest withholding rate would have been reduced to

10% or less. The Court of Appeal applied a substance over form approach and

decided that Newco would not be the beneficial owner of the interest:

92

It is interesting to note that section 9D of the South African ITA was amended shortly after the decision in the Bricom case to add the words “amounts equal to the net income” of the CFC, which could imply that the legislator was concerned that the direct attribution of the income may contravene DTA obligations.

93 [2006] STC 1195.

29

“But the meaning to be given to the phrase “beneficial owner” is plainly not to be limited

by so technical and legal an approach. Regard is to be had to the substance of the

matter. In both commercial and practical terms the Issuer is, and Newco would be, bound

to pay on to the Principal Paying Agent that which it receives from the Parent Guarantor.

…

[the role of Newco in the structure] can hardly be described as the “full privilege” needed

to qualify as the beneficial owner, rather the position of the Issuer and Newco equates to

that of an “administrator of income”].

The Court concluded: “that the term ‘beneficial owner’ is to be given an international fiscal meaning not derived

from the domestic law of contracting states. As shown by those commentaries and

observations, the concept of beneficial ownership is incompatible with that of the formal

owner who does not have ‘the full privilege to directly benefit from the income’.”

The UK IFA Report points out that the Court relied on both the 1986 OECD

Conduit Company Report and the 2003 OECD Commentary on the OECD

Model DTA to arrive at the “international fiscal meaning” which is distinguished

from the narrower “UK technical meaning of the Beneficial ownership” concept

which applies under English law.94

3.3 THE GERMAN APPROACH

The general anti-avoidance provision under German tax law applies to

domestic as well as international transactions, and allows taxes to be levied on

the “adequate” substance of a transaction rather than on the “inadequate” legal

form, in order to prevent tax avoidance through abusive transactions. The

application of this provision in a DTA context is seen as the determination of the

“right” rather than the “alleged” facts and, thus, as not being in conflict with the

DTA.95 This general substance-over-form rule is backed up by a wide range of

special anti-avoidance provisions in German international tax law. Where these

rules are in conflict with DTAs, they are applied nonetheless as DTA overrides

have been accepted by the tax courts in Germany.96

To prevent the abuse of a DTA through conduit company structures, essentially

to reduce German withholding taxes, Germany introduced a special anti-treaty

abuse provision into its domestic law97. Under the provision, a foreign entity is

not entitled to DTA benefits if its shareholders would not be entitled to these

benefits had they received the payments directly, and

there are no commercial or other relevant non-tax reasons for the

interposition of the foreign entity; or

94

UK IFA Report at823. 95

German IFA Report in the IFA 2010 Report at 333. 96

Ibid at 341; see also A Linn GeneralthemaI Steuerumgehung und Abkommensrecht IStR (2010) 542 at 543.

97 § 50d Abs. 3 Satz 1 EStG; see the German IFA Report at 336 – 337.

30

the foreign company earns no more than 10% of its gross earnings

from a business activity of its own; or

the foreign company is not adequately equipped to take part in

business operations given its purpose.

The German courts have upheld the application of these specific anti-abuse

provisions in the context of a DTA98 , but the German Constitutional Court

(Bundesverfassungsgericht (BVerfG)) gave two judgments in 2004 which may

have the impact to limit the scope for treaty override.99

Whilst the scope of the specific anti-avoidance rules are reasonably clear, there

is an intense debate about the scope of the general anti-avoidance provisions,

in particular to what extent “aggressive tax planning” may exceed the realms of

legitimate planning and should be treated as “abuse”.100 This uncertainty is a

serious problem in Germany in view of the decisions by the German tax courts

that a director of a company or a tax advisor has the obligation to utilize or

advise of the most efficient tax structures otherwise they could become liable to

damages.101

The German tax courts have confirmed that the specific anti-treaty abuse

provisions override the general anti-tax avoidance provisions of AO 42.102

3.4 THE US APPROACH

The US does not currently have a general statutory anti-avoidance rule, but the

tax courts have developed anti-abuse doctrines that may be used by the

Internal Revenue Service (IRS) to challenge a transaction.103 These doctrines

include the business purpose, economic substance, step transaction,

substance over form and sham transaction doctrines. 104 These anti-abuse

doctrines may be applied in the international context, including when DTAs are

involved.105 In addition to these anti-abuse doctrines, the US tax rules (the

Internal Revenue Code) contain several specific international anti-avoidance

rules106.

98

German IFA Report at 341, which refers to the decision in BFH, I R 120/93, BStBl. II 1995, 129 as support.

99 German IFA Report at 341.

100 Wolfgang Blumers, Aggressive Steuerplanung, – Vielleicht legal, aber jedenfalls

verwerflich, Beriebs Berater, 2013, Beck-online at 2785. 101

Blumers at 2785; also Pinkernell at 9. 102

R Klein, AO § 42 Missbrauch von rechtlichen Gestaltungsmöglichkeiten, Becks online, at 143.

103 USA IFA Report, in the 2010 IFA Report in para 1.1 at 827.

104 Ibid.

105 Ibid.

106 Ibid.

31

A transaction may be disregarded if the court finds it to be a "sham", devoid of

genuine substance.107 Thus, if the form employed for the transaction is unreal it

can be ignored and effect can be given to the actual transaction performed.108

More often however, the "substance over form" test is applied.109 In such cases

the taxpayer intends that effect should be given to the actual transaction

performed. Since the form used is not covered by the literal provision of the

statute, the taxpayer manages to escape taxation. In substance, however, he

has achieved the economic result which the statute aims to cover. A court may,

under certain circumstances, ignore the form of the transaction and consider its

substance, e.g. a loan to an associated company may be treated as, in

substance, a contribution to equity capital.110

The US IFA Report confirms that the substance over form principle has been

used to disregard intermediate entities as mere “conduits” or “shams” where

they are used to obtain DTA benefits.111

Tax avoidance schemes often rely upon the separate fiscal identity of a

corporation. Although the IRS has often argued that the corporate identity of an

interposed corporation in a treaty shopping scheme should be ignored since it

is a mere sham, the courts have not readily accepted this argument. The test to

determine whether a corporation should be recognised as an independent fiscal

entity was established in the Moline Properties Inc v CIR. 112 As long as there

was a valid business purpose for the existence of the corporation or it carried

out substantive business activities, its separate fiscal entity should be

respected.113 If a tax avoidance scheme consists of several separate steps, the

various stages may be amalgamated and treated as one transaction if the steps

are interdependent and are directed at a particular end result (the so-called

"step-transaction" doctrine).114

A test which has been applied frequently to counter treaty shopping schemes is

the "conduit test". The classical case in which the test was so applied is Aiken

107

Higgins v Smith 40-1 USTC 9160; Moline Properties Inc v CIR, 43-1 USTC 9464 esp at 391; also the comments in the US Report on “Tax Avoidance/Tax Evasion” in Cahiers De Droit Fiscal International, Vol XXXVII, 1983, page 333 esp at 335.

108 US IFA Report in para 1.2.2 at 829, where it concludes that the Gregory case is viewed as

a precedent for the disregard of the transfer of an asset without a business purpose but solely to reduce a tax liability.

109 Gregory v Helvering 35-1 USTC, 9043, esp at 420; also the comments in the US IFA

Report in para 1.2.1 at 829. 110

US Report, Cahiers De Droit Fiscal International, Vol La, 1970 at 301; also Knetch v United States 60-2 USTC 9785.

111 US IFA Report in para 1.2.1 at 829 which refers to the decision in Teong-Chan Gaw v

Commissioner, T.C. Memo, 1995-531, 70 T.C.M. 1196. 112

43-1 USTC 9464 esp at 391. 113

US IFA Report at 829. 114

US IFA Report in para 1.2.3 at 832.

32

Industries Inc v CIR115. In accordance with this test the entity is regarded as a

conduit since it is not in substance the beneficial owner of the income received

from the source State. It merely passes the income on to the ultimate

beneficiary. Therefore, it is not entitled to treaty benefits. The most significant

cases on treaty "abuse" are analysed below to illustrate the attitude of the US

courts.

In the case of Maximov v US116, the petitioner was a private trust (represented

by Maximov) which had been created in the US by a resident and citizen of the

U.K. The grantor, his wife and their children were the beneficiaries (all residents

of the U.K.). The trust which was administered in the US, realized capital gains

income upon the sale of certain of its assets during 1954 and 1955. The

petitioner claimed exemption from a liability for US income tax on its realized

and retained capital gains. As support for this claim he relied on article XIV of

the DTA between the U.S and the U.K. which provides:

"A resident of the United Kingdom not engaged in trade or business in the United

States shall be exempt from United States tax on gains from the sale, or exchange of

capital assets."

The petitioner argued that, since the real burden of the tax fell upon the

beneficiaries of the trust all of whom were residents of the UK, the DTA should

have been read as exempting the trust from the tax asserted by the US, i.e. the

trust should not have been regarded as a taxable entity. The court could find no

support in the plain language of the DTA for petitioner's argument in favour of

disregarding the trust entity. It pointed out that the exemption provided for by

article XIV applies only to a resident of the UK. Article 11(i)(g) defines a UK

resident as "any person (other than a citizen of the United States or a United

States corporation) who is a resident in the UK for the purposes of UK tax and

not resident in the United States for purposes of United States tax. The word

"person" is not defined in the DTA and therefore recourse must be had to the

domestic tax law of the State applying the DTA, i.e. the US, to determine its

meaning (in accordance with article 11(3) of the DTA). Under US law "person"

includes a "trust". Therefore the trust was regarded as a taxable entity, distinct

from its beneficiaries and was held to be a resident of the US for purposes of

US tax.

Petitioner's claim was, however, supported by a second argument. He argued

that equality of tax treatment was an objective for the conclusion of the DTA

and that a court had to further this objective. In the petitioner's view the court

was compelled to adopt the theory that exemption had to be granted whenever

the burden of the tax diminished such equality. The UK imposed no tax on

capital gains and therefore, the petitioner claimed, no similar tax could be

115

56 T. C. 925 (1971) – see analysis of the case below. 116

63-1 USTC 9438.

33

imposed by the US. The court considered the purpose of the DTA and

concluded that the general purpose is not to ensure complete and strict equality

of tax treatment but rather to facilitate commercial exchange through the

elimination of double taxation; an additional purpose is the prevention of fiscal

evasion. Neither of these purposes required relief in the situation presented as

the beneficiaries did not pay tax on the US income of the trust in the UK and

fiscal evasion was not involved. The court thus refused to read the DTA in such

a way as to accord unintended benefits, inconsistent with its words and not

compellingly indicated by its purpose.

A fine example of "treaty shopping" is the case of Ingemar Johannson v US.117

Johannson, a citizen of Sweden, fought Patterson for the heavyweight boxing

championship of the world in three consecutive fights during 1960 and 1961.

Johannson formed a service (base) corporation in Switzerland to obtain certain

treaty benefits of the US - Switzerland double taxation agreement, i.e. the

exemption from US source tax provided for by article X(1) of the treaty. To

obtain this benefit Johannson had to prove that he was a resident of

Switzerland and that he received the income as an employee of, or under

contract with, a Swiss corporation.

The court first examined whether US tax law provides for the taxation of

Johannson's income. Section 871(C) of the Internal Revenue Code, 1954,

provided at the time that a non-resident alien individual engaged in trade or

business within the US shall be taxable there. The term "engaged in trade or

business within the US" includes the performance of personal services within

the US at any time within the taxable year. The court then enquired whether a

DTA required a contrary result. It found no contrary provision in the US DTA

with Sweden. As Johannson, however, relied on the US - Switzerland DTA the

court proceeded to examine its provisions. The term “resident" is nowhere

defined in the DTA. In accordance with article II(2) the contracting State,

applying the DTA, should revert to its own national law definition, if the DTA

does not define a term.(291) As the criteria applied to determine the meaning are

the same in both States the court regarded article II(2) as unimportant.

On the evidence before it, the court concluded that Johannson was not a

resident of Switzerland as his social and economic ties, during the relevant

time, remained predominantly with Sweden. The court also considered the

second condition which had to be fulfilled before DTA benefits could be

claimed, i.e. that the recipient must have received the income as an employee

of, or under contract with, a Swiss corporation.

117

64-2 USTC 9743.

34

The court established that the corporation had no legitimate business purpose

and therefore held it to be a device used by Johannson to divert his US income

so as to escape US taxes. The fact that Johannson was motivated in his

actions by the desire to minimize his tax burden was, however, not the reason

why the exemption, to which he was entitled in accordance with the DTA

provision, was refused. The court stressed that the specific words of a DTA

should be given a meaning consistent with the genuine shared expectations of

the contracting parties, and to do this was necessary to examine not only the

language (i.e. the literal text), but the entire context of the DTA.

In the court's opinion the main objective of the DTA with Switzerland was the

elimination of the impediments to international commerce resulting from double

taxation. As a general rule, applied in DTAs, the income from services is

taxable where the services are rendered. Exceptions to this rule are made to

avoid taxation of an enterprise in every country where it is active or of agents

and employees of such firms. Where the circumstances do not warrant an

exception, the general rule must be applied. Thus the court held that

Johannson had failed to establish any substantial reasons for deviating from the

DTA's basic rule (income from services is taxable where the services are

rendered) in spite of the fact that he had brought himself within the words of the

DTA. The court concluded that international trade would not be seriously

encumbered by its refusal to give special tax treatment to one only marginally, if

at all, Swiss resident who was only technically, if at all, employed by a paper

Swiss corporation.

In Perry Bass v. Commissioner of Internal Revenue118 the taxpayer successfully

used the US - Switzerland DTA to avoid US taxes. The petitioners (Perry and

Nancy Lee Bass) were citizens and residents of the US. Perry Bass organised

a Swiss corporation, Stantus AG, and acquired, for cash, all the stock except

three shares, which were held by the directors for the benefit of the petitioner.

He then transferred, to the corporation, a substantial share of his interest in

certain oil producing properties in the US. The corporation thereafter signed

working agreements, collected royalties, made investments and carried out

other business activities. Stantus AG reported the income from these interests

on its US and Swiss tax returns, but claimed exemption from US taxes under

the DTA between the US and Switzerland.

The sole issue, in the court's view, was whether Stantus AC could be

disregarded for tax purposes so that the income and losses of the corporation

would constitute the income and losses of the petitioner. The court stressed

that a taxpayer may adopt any form he desires for the conduct of his business,

and that the chosen form cannot be ignored merely because it results in tax

118

50 T.C. 595 (1968).

35

saving. To be afforded recognition, however, the form the taxpayer chooses

must be a viable business entity, i.e. it must have been formed for a substantial

business purpose or actually engage in substantive business activity.

After considering the facts, the court concluded that Stantus AG was a viable

business corporation. It was duly organised in accordance with Swiss law, and

also carried out activities which a viable corporation normally carries out. The

fact that an owner of a corporation (the petitioner in this case) retains direction

of its affairs down to the minutest details affords no ground for disregarding it as

a separate corporate entity. The court acknowledged that the corporation was

formed with the aim to reduce US taxes but, in its opinion, the test is not the

personal purpose of the taxpayer in creating a corporation, but rather whether

he intends to reduce US taxes by using a corporation which carries out

substantive business functions. The corporation was thus regarded as a

separate tax entity which implied that it was taxable in Switzerland in

accordance with the US - Switzerland DTA.

It should be noted that Bass had requested a tax ruling from the US IRS as to

the validity of the proposed scheme. The ruling confirmed that Stantus AG

would be exempt from US tax under the US Switzerland tax DTA.

Another example of unsuccessful "treaty shopping" is the Aiken Industries case

(see reference above). Aiken Industries Inc., a US corporation, borrowed

money from its parent corporation situated in the Bahamas. To avoid US

withholding (source) taxes on interest payments by Aiken Industries to its

parent corporation, the parent corporation created a corporation in Honduras

and assigned its rights and interest in the promissory note (issued by Aiken

Industries) to this corporation. The US - Honduras DTA provided that interest

received by a resident or corporation of a contracting State, from sources within

the other State, would be exempt from source taxation in the other State if the

receiver of the interest had no permanent establishment there.

In support of its claim for exemption under the DTA, the petitioner argued that

the Honduran corporation conformed to the definition of a corporation provided

for in article II(1)(g) of the DTA. The court pointed out that DTAs are the

supreme law of the land and superior to domestic tax laws. Consequently the

courts and tax authorities must apply the definitions expressly set forth in the

DTA. Therefore, when the formal requirements of a definition in a DTA are met

the benefits flowing from the DTA, as a result of conforming to such formal

requirements, cannot be denied by an enquiry behind those formal

requirements. The Honduran corporation did fulfill the definitional requirements

of the DTA and therefore, the court had to recognize it as a taxable entity for

purposes of the DTA.

36

This fact alone was, according to the court, not sufficient to qualify the interest

in question for the exemption from tax granted by article IX of the DTA. A

further condition required by article IX was that the interest payments had to be

"received by" the corporation in the other contracting State. The meaning of

"received by" had to be established by the court. Under article II(2) of the DTA,

terms not otherwise defined had to carry the meaning which they normally had

under the laws of the State which applied the DTA unless the context required

otherwise. In order to give the specific words of a DTA a meaning consistent

with the genuine shared expectations of the contracting States, it is necessary

to examine not only the language but the entire context of the DTA.

The court applied these principles and found that the interest payments were

not "received by" a corporation of a contracting State within the meaning of

article IX. "Received by" was interpreted to mean not merely the obtaining of

physical possession of such interest on a temporary basis, but to contemplate

dominium and control over the funds. The petitioner could not prove that a

substantive indebtedness existed between the US corporation and the

Honduran corporation.

The assignment of the debt between the Bahamian corporation and the

Honduran corporation had no valid business purpose. A tax avoidance motive

is generally not regarded as fatal to a transaction, but such a motive, standing

by itself is not a business purpose which is sufficient to support a transaction for

tax purposes. The Honduran corporation was thus held to be a mere conduit

which had no actual beneficial interest in the interest payments it "received" and

thus, in substance, the US corporation was paying the interest to the Bahamian

corporation, which received it within the meaning of article IX of the US —

Honduran DTA.

In Compagnie Financiere De Suez et de L'Union Parisienne v US 119 the

taxpayer attempted to use a double taxation agreement to avoid US source tax.

The "Compagnie Financiere de Suez et de L'Union Parisienne" was the

corporation that built and operated the Suez Canal until it was nationalized on

July 26, 1956. The corporation entered into a trust agreement with J.P. Morgan

and Co. Inc. of New York, on January 17 1949. A revocable trust was created.

The corporation designated JP Morgan and Co. Inc. as trustee of a trust fund

for the purpose of enabling the corporation to fund, or otherwise secure, its

pension obligations. Current trust income, exclusive of capital gains was to be

paid over to the corporation as of 1 December each year. The trustee had to

withhold the US source tax on interest and dividend payments which the trust

made to foreigners, in accordance with the US Internal Revenue Code. The

corporation identified itself, on all the tax returns it filed, as an Egyptian

119

74-1 USTC 9254.

37

corporation. It received the dividends and interest paid by the trust. At no time

during the years from 1952 — 1956 did the corporation have a permanent

establishment in the US. On January 14 1959 it filed refund claims for the

withholding tax levied in the US.

The basis for the plaintiff's claim was that it was a French corporation for the

purposes of article 6(A) of the DTA between France and the US as its

administrative domicile was in Paris (according to article 3, of the articles of

incorporation). Furthermore all the corporation's major administrative functions,

performed during its operating history, were done through its general

administrative office in Paris. All the officers and all the agents of the

corporation, resident in Egypt, with one exception, were French citizens. The

corporation was subject to French jurisdiction for purposes of handling its

securities (but the securities were treated as foreign for tax purposes).

Countervailing factors were that the corporation had its designated head office,

its primary place of business and its basic source of income in Egypt. After

considering the history of the corporation the court concluded that it was an

Egyptian corporation from 1952 to 1956. It was, therefore, not entitled to the

reduced tax rate on US interest and dividend payments, as provided in the DTA

between the US and France and it was thus not entitled to refunds.

The corporation was created under Egyptian law, and Egypt exercised

sovereign power over it. Its head office was in Egypt and all its profit-making

business was carried on outside of France. Moreover, it was not subject to

French tax. As support for this finding, based on facts, the court relied on a US

Treasury Regulation (1961) which was an attempt to define the concept

"French enterprise" or "French corporation or other entity" for purposes of the

tax DTA with France. According to the Regulation an enterprise carried on

wholly outside France, by a French corporation, is not a French enterprise

within the meaning of the DTA. The court expressed the opinion that the

Regulation was an attempt to prevent corporations that were incorporated in

France, but which conducted all their profit-making business outside France in

order to avoid French tax, to claim tax benefits of DTAs to which France was a

signatory. Therefore, even if the corporation had been created in France under

French law, it would not have qualified for DTA benefits.

To further justify the decision, the court considered the purpose of the tax DTA.

It concluded that the main purpose was to avoid double taxation and, as the

corporation paid no taxes in France, there was no such burden. Thus, there

was no need for the DTA to be applied.

38

The US tax courts have also applied the “step transaction doctrine” to counter

DTA abuse.120 The USA IFA Report points out that the step transaction doctrine

may be viewed as another variation of the “substance over form” principle: In

determining whether steps should be integrated under the step transaction

doctrine, courts and the IRS typically have applied three alternative tests. In the

strictest test, the “binding commitment” test, a series of transactions will be

“stepped together” only if, at the time the first step occurs, there is a binding

commitment to undertake the subsequent steps. In the “mutual

interdependence” test, a series of transactions will be stepped together if the

steps were “so interdependent that the legal relations created by one

transaction would have been fruitless without a completion of the series”. Under

the “end result” test, a series of transactions will be stepped together if the

parties’ intent, at the commencement of the transactions, was to achieve the

particular result and the steps were all entered into to achieve that result.”121

In Del Commercial Properties Inc v Commissioner,122 Delcom Financial Ltd

(Financial), a Canadian corporation obtained an $18 million loan from a third-

party bank. Delcom Financial then loaned $14 million of the loan to its wholly

owned Canadian subsidiary, which then contributed $14 million to its wholly

owned Cayman subsidiary, which contributed the $14 million to its wholly

owned Netherlands-Antilles subsidiary, which contributed the $14 million to its

wholly owned Netherlands subsidiary. The Netherlands subsidiary then loaned

the $14 million to Delcom Commercial in the US. Initially, the taxpayer made its

payments under the loan to the Netherlands subsidiary, but later it made

payments directly to Delcom Financial, ignoring the intermediate parties. The

IRS argued that the real loan was made by Delcom Financial to Delcom

Commercial and that interest payments were subject to 15 per cent withholding

under the 1985 USA–Canada DTA. The taxpayer argued that the loan from the

Netherlands subsidiary to Delcom Commercial should be respected and that

the interest payments were not subject to withholding under the US

Netherlands DTA.

The court denied the DTA relief on the basis of the step transaction doctrine,

stating that a step in a series of transactions would be ignored if the step does

“not appreciably affect [the taxpayer’s] beneficial interest except to reduce his

tax”.123 The court referred to two Revenue Rulings from the IRS, which provide

that “if the sole purpose of the transaction with a foreign country is to dodge US

taxes, the treaty cannot shield the taxpayer from the fatality of the step-

120

USA IFA Report in para 1.2.3 at 832. 121

Ibid. 122

251 F.3rd

505, 512 (DC Cir. 2000). 123

USA IFA Report at.833.

39

transaction doctrine. For the taxpayer to enjoy the treaty’s tax benefits, the

transaction must have a sufficient business or economic purpose.”124

The US IFA Report concludes that the court’s decision appears to be grounded

more in the substance over form and conduit principles, since Delcom

Commercial could not show that BV had “any business or economic purpose

sufficient to overcome the conduit nature of the transaction”. 125

In general, the US courts have applied the domestic anti-abuse rules to counter

DTA abuse, i.e. they have not viewed the application of such rules as

inconsistent with the DTAs.126 In terms of the US Constitution, federal domestic

law and DTAs are on an equal footing; whilst a court will attempt to give effect

to both, if there is a clear conflict, the later in time will prevail.127 Several specific

anti-avoidance rules directly limit the application of DTA provisions and may

possibly be regarded as in conflict with US DTA obligations.128

The US has introduced many specific and general anti-avoidance provisions in

its DTAs. 129 The most prominent is the US Limitation of Benefits (LOB)

provision in Article 21 of the US Model DTA.130 The LOB provision in US DTAs

has been criticized for its inflexibility. For example, if a South African Group

should hold its international investments via a Netherlands holding company

(Holdco), which is typically established for many other reasons apart from tax

benefits, that Holdco will not be entitled to the benefits of the Netherlands/US

DTA, even though the South African parent company is entitled to virtually the

same benefits under the US/South Africa DTA. The test is applied very rigidly,

without consideration of the wider circumstances.

4 THE OECD BEPS PROJECT

When the OECD issued its 2013 Report on base erosion and profit shifting

(BEPS),131 it noted, in Action 6, that although current rules to prevent treaty

abuse work well in many cases, they need to be adapted to prevent BEPS that

results from the interactions among more than two countries, and to fully

account for global value chains. The OECD recommends that:

Existing domestic and international tax rules should be modified in order to

more closely align the allocation of income with the economic activity that

generates that income.

124

Ibid. 125

Ibid. 126

Ibid, par 1.4 at.837. 127

Ibid, par 1.4.2 at.838. 128

Ibid, par 1.4.3 at. 839. 129

Ibid, par 2 at 840. 130

Article 22 of the US/South Africa DTA. 131

OECD Action Plan on Base Erosion and Profit Shifting (2013) at 19.

40

To address treaty abuse, the OECD embarked on work to:

Develop changes to model treaty provisions and provide recommendations

regarding the design of domestic rules to prevent the granting of treaty benefits

in inappropriate circumstances.

Clarify that tax treaties are not intended to be used to generate double non-

taxation.

Identify the tax policy considerations that, in general, countries should consider

before deciding to enter into a tax treaty with another country.

In September 2014 the OECD issued a Report132 on Action 6 and a Final report

was issued in 2015,133 a summary of its recommendations is set out below:

4.1 OECD RECOMMENDATIONS REGARDING THE DESIGN OF

DOMESTIC RULES TO PREVENT THE GRANTING OF TREATY

BENEFITS IN INAPPROPRIATE CIRCUMSTANCES

The September 2015 Final Report on Action 6, sets out recommendations

intended to prevent the granting of treaty benefits in inappropriate

circumstances. The OECD noted that a distinction has to be made between:

c) Cases where a person tries to circumvent the provisions of domestic tax

law to gain treaty benefits. In these cases, treaty shopping must be

addressed through domestic anti-abuse rules (as discussed above).134

d) For cases where a person tries to circumvent limitations provided by the

treaty itself, the OECD recommends treaty anti-abuse rules, using a

three-pronged approach:

(iv) The title and preamble of treaties should clearly state that the

treaty is not intended to create opportunities for non-taxation or

reduced taxation through treaty shopping.135 Such a provision

augments the treaty interpretation approach of preventing treaty

abuse in article 31 of the Vienna Convention on the Law of

Treaties which provides that treaties are to be interpreted in

good faith and in the light of the object and purpose of the

treaty.136

132

OECD/G20 Base Erosion and Profit Shifting Project “Preventing the Granting of Treaty Benefits in Inappropriate Circumstances Action 6: 2014 Deliverable” (2014). (OECD/G20 September 2014 Report on Action 6).

133 OECD/G20 Base Erosion and Profit Shifting Project “Preventing the Granting of Treaty Benefits in Inappropriate Circumstances” (2015 Final Report))



136 Vienna Convention on the Law of Treaties of 23 May 1969

41

(v) The inclusion of a specific limitation-of-benefits provisions (LOB

rule), which is normally included in treaties concluded by the

United States and a few other countries: The OECD is of the

view that such a specific rule will address a large number of

treaty shopping situations based on the legal nature, ownership

in, and general activities of, residents of a Contracting State. 137

(vi) To address other forms of treaty abuse, not being covered by

the LOB rule (such as certain conduit financing arrangements),

tax treaties should include a more general anti-abuse rule

based the principal purposes (PTT) rule. This rule is intended to

provide a clear statement that the Contracting States intend to

deny the application of the provisions of their treaties when

transactions or arrangements are entered into in order to obtain

the benefits of these provisions in inappropriate circumstances.

138

The OECD acknowledges that each rule has strengths and weaknesses and

may not be appropriate for all countries.139 It thus advises that the rules may be

adapted to the specificities of individual States and the circumstances of the

negotiation of DTAs. For example, some countries may have constitutional or

certain legal restrictions that prevent them from adopting the recommendation.

Some countries may have domestic anti-abuse rules or interpretative tools

developed by their courts that prevent some of the treaty abuses. In other

cases, the administrative capacity of some countries (a major issue in African

countries) may prevent them from applying certain detailed anti-abuse rules

and require them to adopt more general anti-abuse provisions (for example the

PPT rule).140 Nevertheless, the OECD recommends that at a minimum level, to

protect against treaty abuse, countries should include in their tax treaties an

express statement that their common intention is to eliminate double taxation

without creating opportunities for non-taxation or reduced taxation through tax

evasion or avoidance, including through treaty shopping arrangements.141 This

intention should be implemented through either:

- using the combined LOB and PPT approach described above; or


- the inclusion of LOB rule supplemented by a mechanism (such as a

restricted PPT rule applicable to conduit financing arrangements or

domestic anti-abuse rules or judicial doctrines that would achieve a

137


Ibid. 139

OECD/G20 2015 Final Report on Action 6 in para 21 140



42

similar result) that would deal with conduit arrangements not already

dealt with in tax treaties. 142

4.2 OECD RECOMMENDATIONS REGARDING OTHER SITUATIONS

WHERE A PERSON SEEKS TO CIRCUMVENT TREATY

LIMITATIONS

The OECD noted that although the general anti-abuse rule will be useful in

addressing treaty abuse situations, it is also important to have targeted specific

treaty anti-abuse rules which generally provide greater certainty for both

taxpayers and tax administrations. Such rules are already found in some

Articles of the Model Tax Convention; for example: Articles 13(4) and 17(2)). 143

In addition, the OECD provides the following examples of situations with

respect to which specific treaty anti-abuse rules may be helpful, and makes

proposals for changes intended to address some of these situations. 144

Splitting-up of contracts: The OECD notes that paragraph 18 of the

Commentary on Article 5 indicates that “[t]he twelve-month threshold [of Article

5(3)] has given rise to abuses; it has sometimes been found that enterprises

(mainly contractors or subcontractors working on the continental shelf, or

engaged in activities connected with the exploration and exploitation of the

continental shelf) divided their contracts up into several parts, each covering a

period less than twelve months and attributed to a different company which

was, however, owned by the same group.” 145

- To address these issues the PPT rule will be added to the MTC and the

Report on Action 7 (Preventing the Artificial Avoidance of Permanent

Establishment Status, OECD, 2015) puts forward changes to the

Commentary on Article 5 that will also deal with the issue.146

Hiring-out of labour cases: Where a taxpayer attempts to obtain,

inappropriately, the benefits of the exemption from source taxation provided for

in Article 15(2) by hiring-out of labour.

- The OECD notes that these treaty abuses can already be dealt with by the

guidance provided in paragraphs 8.1 to 8.28 of the Commentary on Article

15 and in the alternative provision found in paragraph 8.3 of that

Commentary. 147

142

OECD/G20 2015 Final Report on Action 6 at 21. 143






43

Transactions intended to avoid dividend characterisation: The OECD notes that

in some cases, transactions may be entered into for the purpose of avoiding

domestic law rules that characterise a certain item of income as a dividend and

to benefit from a treaty characterisation of that income (e.g. as capital gain) that

prevents source taxation. 148

- The OECD notes that its work on hybrid mismatch arrangements,

examined whether the treaty definitions of dividends and interest could be

amended, as is done in some treaties, in order to permit the application of

domestic law rules that characterise an item of income as such. Although

it was concluded that such a change would have a very limited impact with

respect to hybrid mismatch arrangements, it was decided to further

examine the possibility of making such changes after the completion of the

work on the BEPS Action Plan. 149

Dividend transfer transactions: In dividend transfer transactions, a taxpayer

entitled to the 15 per cent portfolio rate of Article 10(2)(b) may seek to obtain

the 5 per cent direct dividend rate of Article 10(2)(a) or the 0 per cent rate that

some bilateral conventions provide for dividends paid to pension funds.150 The

concern is that Article 10(2)(a) does not require that the company receiving the

dividends must have owned at least 25 per cent of the capital for a relatively

long time before the date of the distribution. This means that all that counts

regarding the holding is the situation prevailing at the time material for the

coming into existence of the liability to the tax to which Article 10(2)(a) applies.

To prevent any abuse that might arise, it is necessary to require the parent

company to have possessed the minimum holding for a certain time before the

distribution of the profits could involve extensive inquiries. Internal laws of

certain OECD member countries provide for a minimum period during which the

recipient company must have held the shares to qualify for exemption or relief

in respect of dividends received.

- The OECD recommends that Contracting States may include a similar

condition in their conventions to ensure that the reduction envisaged in

Article 10(2)(a) is not granted in cases of abuse of this provision, for

example, where a company with a holding of less than 25 per cent has,

shortly before the dividends become payable, increased its holding

primarily for the purpose of securing the benefits of the abovementioned

provision, or otherwise, where the qualifying holding was arranged

primarily in order to obtain the reduction. 151

148





44

- The OECD concluded that in order to deal with such transactions, a

minimum shareholding period should be included in Article 10(2)(a) to

read as follows: a) 5 per cent of the gross amount of the dividends if the beneficial owner is a

company (other than a partnership) which holds directly at least 25 per cent of

the capital of the company paying the dividends throughout a 365 day period

that includes the day of the payment of the dividend (for the purpose of

computing that period, no account shall be taken of changes of ownership that

would directly result from a corporate reorganisation, such as a merger or

divisive reorganisation, of the company that holds the shares or that pays the

dividend). 152

- It was also concluded that additional anti-abuse rules should be included

in Article 10 to deal with cases where certain intermediary entities

established in the State of source are used to take advantage of the treaty

provisions that lower the source taxation of dividends.153

Transactions that circumvent the application of Article 13(4): Article 13(4) allows

the Contracting State in which immovable property is situated to tax capital

gains realised by a resident of the other State on shares of companies that

derive more than 50 per cent of their value from such immovable property. 154

Paragraph 28.5 of the Commentary on Article 13 already provides that States

may want to consider extending the provision to cover not only gains from

shares but also gains from the alienation of interests in other entities, such as

partnerships or trusts, which would address one form of abuse.

- It was agreed that Article 13(4) should be amended to include such

wording. 155

The OECD also notes that there might also be cases, however, where assets

are contributed to an entity shortly before the sale of the shares or other

interests in that entity in order to dilute the proportion of the value of these

shares or interests that is derived from immovable property situated in one

Contracting State.

- In order to address such cases, it was agreed that Article 13(4) should be

amended to refer to situations where shares or similar interests derive

their value primarily from immovable property at any time during a certain

period as opposed to at the time of the alienation only. 156

Tie-breaker rule for determining the treaty residence of dual-resident persons

other than individuals: The OECD notes that one of the key limitations on the

granting of treaty benefits is the requirement that a person be a resident of a

152






45

Contracting State (article 4) for the purposes of the relevant tax treaty. Article

4(3), which deals with persons other than individuals, provides that the dual-

resident person “shall be deemed to be a resident only of the State in which its

place of effective management is situated”. When this rule was originally

included in the 1963 Draft Convention, the OECD Fiscal Committee expressed

the view that “it may be rare in practice for a company, etc. to be subject to tax

as a resident in more than one State” but because that was possible, “special

rules as to the preference” were needed. 157 The 2008 Update to the OECD

Model Tax Convention introduced an alternative version of Article 4(3) (in

paragraphs 24 and 24.1 of the Commentary on Article 4) according to which the

competent authorities of the Contracting States shall, having regard to a

number of relevant factors, endeavour to determine, by mutual agreement, the

State of which the person is a resident for the purposes of the Convention. The

OECD discussed an alternative version, and the view of many countries was

that cases where a company is a dual resident often involve tax avoidance

arrangements.

- It was recommended that the current POEM rule found in Article 4(3)

should be replaced by the alternative found in the Commentary, which

allows a case-by-case solution of these cases. 158

- Thus instead of providing that a person, other than an individual, that is a

resident of both Contracting States, shall be deemed to be a resident only

of the State in which its place of effective management is situated, article

4(3) shall be amended to provide that:. the competent authorities of the Contracting States shall endeavour to determine by

mutual agreement the Contracting State of which such person shall be deemed to be a

resident for the purposes of the Convention, having regard to its place of effective

management, the place where it is incorporated or otherwise constituted and any other

relevant factors. In the absence of such agreement, such person shall not be entitled to

any relief or exemption from tax provided by this Convention except to the extent and in

such manner as may be agreed upon by the competent authorities of the Contracting

States. 159

The option is, however, still provided to States negotiating tax treaties to include

a tie-breaker rule that refers to where the POEM is situated.160

Anti-abuse rule for permanent establishments situated in third States:

Paragraph 32 of the Commentary on Article 10, paragraph 25 of the

Commentary on Article 11 and paragraph 21 of the Commentary on Article 12

refer to potential abuses that may result from the transfer of shares, debt-

claims, rights or property to permanent establishments set up solely for that

157




OECD/G20 2015 Final Report on Action 6 in para 49 refer to replacement suggestion para 24.5.

46

purpose, in countries that offer preferential treatment to the income from such

assets. Where the State of residence exempts, or taxes at low rates, profits of

such permanent establishments situated in third States, the State of source

should not be expected to grant treaty benefits with respect to that income. 161

- The last part of paragraph 71 of the Commentary on Article 24 deals with

that situation and it is suggested that an anti-abuse provision could be

included in bilateral conventions to protect the State of source from having

to grant treaty benefits where income obtained by a permanent

establishment situated in a third State is not taxed normally in that

State.162

Triangular abuse cases may also arise. If the Contracting State of which the

enterprise is a resident exempts from tax the profits of the permanent

establishment located in the other Contracting State, an enterprise can transfer

assets such as shares, bonds or patents to permanent establishments in States

that offer very favourable tax treatment and, in certain circumstances, the

resulting income may not be taxed in any of the three States.

- To prevent such abusive practices, a provision can be included in the

convention between the State of which the enterprise is a resident and the

third State (the State of source) stating that an enterprise can claim the

benefits of the convention only if the income obtained by the permanent

establishment, situated in the other State, is taxed normally in the State of

the permanent establishment. 163 Thus the OECD concluded that a

specific anti-abuse provision will be included in the Model Tax Convention

to deal with that and similar triangular cases where income attributable to

the permanent establishment in a third State is subject to low taxation.

4.3 OECD RECOMMENDATIONS IN CASES WHERE A PERSON TRIES TO

ABUSE THE PROVISIONS OF DOMESTIC TAX LAW USING TREATY

BENEFITS

The OECD notes that many tax avoidance risks that threaten the tax base are

not caused by tax treaties but may be facilitated by treaties. In these cases, it is

not sufficient to address the treaty issues: changes to domestic law are also

required. Avoidance strategies that fall into this category include:

• Thin capitalisation and other financing transactions that use tax deductions

to lower borrowing costs;

• Dual residence strategies (e.g. a company is resident for domestic tax

purposes but non-resident for treaty purposes);

• Transfer mis-pricing;

161




47

• Arbitrage transactions that take advantage of mismatches found in the

domestic law of one State and that are

- related to the characterisation of income (e.g. by transforming

business profits into capital gain) or payments (e.g. by transforming

dividends into interest);

- related to the treatment of taxpayers (e.g. by transferring income to

tax-exempt entities or entities that have accumulated tax losses; by

transferring income from non-residents to residents);

- related to timing differences (e.g. by delaying taxation or advancing

deductions).

• Arbitrage transactions that take advantage of mismatches between the

domestic laws of two States and that are

- related to the characterisation of income;

- related to the characterisation of entities;

- related to timing differences.

• Transactions that abuse relief of double taxation mechanisms (by

producing income that is not taxable in the State of source but must be

exempted by the State of residence or by abusing foreign tax credit

mechanisms). 164

The OECD notes that its work on other aspects of the Action Plan, in particular

Action 2 (Neutralise the effects of hybrid mismatch arrangements), Action 3

(Strengthen CFC rules), Action 4 (Limit base erosion via interest deductions

and other financial payments) and Actions 8, 9 and 10 dealing with Transfer

Pricing has addressed many of these transactions. 165

The OECD notes that main objective of its work aimed at preventing the

granting of treaty benefits with respect to these transactions is to ensure that

treaties do not prevent the application of specific domestic law provisions that

would prevent these transactions. Granting the benefits of these treaty

provisions in such cases would be inappropriate to the extent that the result

would be the avoidance of domestic tax. Such cases include situations where it

is argued that

• Provisions of a tax treaty prevent the application of a domestic GAAR;

• Article 24(4) and Article 24(5) prevent the application of domestic thin-

capitalisation

• Article 7 and/or Article 10(5) prevent the application of CFC rules;

• Article 13(5) prevents the application of exit or departure taxes;

• Article 24(5) prevents the application of domestic rules that restrict tax

consolidation to resident entities;

164



48

• Article 13(5) prevents the application of dividend stripping rules targeted at

transactions designed to transform dividends into treaty-exempt capital

gains;

• Article 13(5) prevents the application of domestic assignment of income

rules (such as grantor trust rules). 166

The Commentary on the Articles of the OECD Model already addresses a

number of these issues. For instance:

- Paragraph 23 of the Commentary on Article 1 provides that treaties do not

prevent the application of CFC rules.

- Paragraph 3 of the Commentary on Article 9 suggests that treaties do not

prevent the application of thin capitalisation rules “insofar as their effect is

to assimilate the profits of the borrower to an amount corresponding to the

profits which would have accrued in an arm’s length situation”.

- The Commentary does not, however, address a number of other specific

domestic anti-abuse rules. 167 Nevertheless, paragraphs 22 and 22.1 of

the Commentary on Article 1 provide a more general discussion of the

interaction between tax treaties and domestic anti-abuse rules. These

paragraphs conclude that a conflict would not occur in the case of the

application of certain domestic anti-abuse rules to a transaction that

constitutes an abuse of the tax treaty. 168

- The Commentary does also address other forms of abuse of tax treaties

(e.g. the use of a base company) and possible ways to deal with them,

including “substance-over-form”, “economic substance” and general anti-

abuse rules, particularly as concerns the question of whether these rules

conflict with tax treaties. Paragraph 9.5 of the commentary on article 1

clearly provides a general rule that such rules are part of the basic

domestic rules set by domestic tax laws for determining which facts give

rise to a tax liability; these rules are not addressed in tax treaties and are

therefore not affected by them and they are not in conflict with tax

treaties.169

- Paragraph 9.5 of the Commentary on Article 1 currently offers the

following guidance as to what constitutes an abuse of the provisions of a

tax treaty: “A guiding principle is that the benefits of a double taxation

convention should not be available where a main purpose for entering into

certain transactions or arrangements was to secure a more favourable tax

position and obtaining that more favourable treatment in these

circumstances would be contrary to the object and purpose of the relevant

provisions”.170

166





OECD/G20 2015 Final Report on Action 6 in para 57

49

As indicated above new general anti-abuse rule will be included in the OECD

Model to reinforce the principle already recognised in paragraph 9.5 of the

Commentary on Article, which will provide a clear statement that the

Contracting States want to deny the application of the provisions of their treaty

when transactions or arrangements are entered into in order to obtain the

benefits of these provisions in inappropriate circumstances. The incorporation

of that principle into a specific treaty provision does not modify, however, the

conclusions already reflected in the Commentary on Article 1 concerning the

interaction between treaties and domestic anti-abuse rules; such conclusions

remain applicable, in particular with respect to treaties that do not incorporate

the new general anti-abuse rule. 171 In this regard, it is suggested that the

section on “Improper use of the Convention” currently found in the Commentary

on Article 1 be revised to reflect that conclusion and better articulate the

relationship between domestic anti-abuse rules and tax treaties as indicated

above. 172

Departure or exit taxes

In a number of States, liability to tax on some types of income that have

accrued for the benefit of a resident (whether an individual or a legal person) is

triggered in the event that the resident ceases to be a resident of that State.

Taxes levied in these circumstances are generally referred to as “departure

taxes” or “exit taxes” and may apply, for example, to accrued pension rights and

accrued capital gains. 173

To the extent that the liability to such a tax arises when a person is still a

resident of the State that applies the tax, and does not extend to income

accruing after the cessation of residence, nothing in the Convention, and in

particular in Articles 13 and 18, prevents the application of that form of taxation.

Thus, tax treaties do not prevent the application of domestic tax rules according

to which a person is considered to have realised pension income, or to have

alienated property for capital gain tax purposes, immediately before ceasing to

be a resident. It should be noted though that the provisions of tax treaties do

not govern when income is realised for domestic tax purposes (see, for

example, paragraphs 3 and 7 to 9 of the Commentary on Article 13); also, since

the provisions of tax treaties apply regardless of when tax is actually paid (see,

for example, paragraph 12.1 of the Commentary on Article 15), it does not

matter when such taxes become payable. 174

171





50

The OECD notes however that the application of such taxes, creates risks of

double taxation where the relevant person becomes a resident of another State

which seeks to tax the same income at a different time, e.g. when pension

income is actually received or when assets are sold to third parties. The OECD

notes that such double taxation which is the result of that person being a

resident of two States at different times and of these States levying tax upon

the realisation of different events, is discussed in paragraphs 4.1 to 4.3 of the

Commentary on Article 23 A and 23 B, where it is indicated that mutual

agreement procedure could be used to deal with such cases.

In the case of pensions, for instance, the competent authorities of the two

States could agree that each State should provide relief as regards the

residence-based tax that was levied by the other State on the part of the benefit

that relates to services rendered during the period while the employee was a

resident of that other State. 175 In the case of double taxation situations arising

from the application of departure taxes, the competent authorities of the two

States could agree, through the mutual agreement procedure, that each State

should provide relief as regards the residence-based tax that was levied by the

other State on the part of the income that accrued while the person was a

resident of that other State. This would mean that the new State of residence

would provide relief for the departure tax levied by the previous State of

residence on income that accrued whilst the person was a resident of that other

State, except to the extent that the new State of residence would have had

source taxation rights at the time that income was taxed. The OECD

recommends that states wishing to provide expressly for that result in their tax

treaties are free to include provisions to that effect. 176

4.4 OECD CLARIFICATION THAT TAX TREATIES ARE NOT INTENDED

TO BE USED TO GENERATE DOUBLE NON-TAXATION

The existing provisions of tax treaties were developed with the prime objective

of preventing double-taxation. This was reflected in the title proposed in both

the 1963 Draft Double Taxation Convention on Income and Capital and the

1977 Model Double Taxation Convention on Income and Capital, which was:

“Convention between (State A) and (State B) for the avoidance of double

taxation with respect to taxes on income and on capital”. 177 In 1977, however,

the Commentary on Article 1 was modified to provide expressly that tax treaties

were not intended to encourage tax avoidance or evasion. The relevant part of

paragraph 7 of the Commentary read as follows: “The purpose of double

taxation conventions is to promote, by eliminating international double taxation,

exchanges of goods and services, and the movement of capital and persons;

175




51

they should not, however, help tax avoidance or evasion”. 178 In 2003, that

paragraph was amended to clarify that the prevention of tax avoidance was

also a purpose of tax treaties. Paragraph 7 now reads as follows: “The principal

purpose of double taxation conventions is to promote, by eliminating

international double taxation, exchanges of goods and services, and the

movement of capital and persons. It is also a purpose of tax conventions to

prevent tax avoidance and evasion”. 179

In order to provide the clarification required by Action 6, it has been decided to

state clearly, in the title recommended by the OECD Model Tax Convention,

that the prevention of tax evasion and avoidance is a purpose of tax treaties.

Thus preamble to the OECD MTC will expressly provide that States that enter

into a tax treaty intend to eliminate double taxation without creating

opportunities for tax evasion and avoidance. Given the particular concerns

arising from treaty shopping arrangements, it has also been decided to refer

expressly to such arrangements as one example of tax avoidance that should

not result from tax treaties. 180 As a result of work on Action 6 the preamble to

the convention will now read as follows: “(State A) and (State B),

Desiring to further develop their economic relationship and to enhance their co ‑

operation in tax matters, Intending to conclude a Convention for the elimination of

double taxation with respect to taxes on income and on capital without creating

opportunities for non-taxation or reduced taxation through tax evasion or avoidance

(including through treaty-shopping arrangements aimed at obtaining reliefs provided in

this Convention for the indirect benefit of residents of third States.”

4.5 OECD RECOMMENDATIONS ON TAX POLICY CONSIDERATIONS

THAT, IN GENERAL, COUNTRIES SHOULD CONSIDER BEFORE

DECIDING TO ENTER INTO A TAX TREATY WITH ANOTHER

COUNTRY OR TO TERMINATE ONE

The OECD under its BEPS project identified tax policy considerations that, in

general, countries should consider before deciding to enter into a tax treaty with

another country (or to terminate a treaty if changes to the domestic law of a

treaty partner raises BEPS concerns). This is especially so for treaties with

certain low or no-tax jurisdictions.181 It was however recognised, that there may

be non-tax factors that can lead to the conclusion of a tax treaty and that each

country has a sovereign right to decide to enter into tax treaties with any

jurisdiction with which it decides to do so.182

178





OECD/G20 2015 Final Report on Action 6 in para 76; OECD Action Plan on Base Erosion and Profit Shifting (2013) at 19.

52

The OECD has proposed to come up with paragraph 15 in its Introduction to

the MTC, which will set out the following factors that countries should take into

consideration if they wish to conclude or terminate a treaty:

- Where a State levies no or low income taxes, other States should

consider whether there are risks of double taxation that would justify a tax

treaty;

- States should also consider whether there are elements of another

State’s tax system that could increase the risk of non-taxation – these

may include tax advantages that are ring-fenced from the domestic

economy;

- States should evaluate the extent to which the risk of double taxation

actually exists in cross-border situations involving their residents; and

they should note that many cases of residence/source juridical double

taxation can be eliminated through domestic provisions for the relief of

double taxation (ordinarily in the form of either the exemption or credit

method) which can operate without the need for tax treaties;

- States should consider the risk of excessive taxation that may result from

high withholding taxes in the source State. Even though double taxation

relief methods may ensure that high withholding taxes do not result in

double taxation, to the extent that such taxes levied in the State of source

exceed the amount of tax normally levied on profits in the State of

residence, they may have a detrimental effect on cross-border trade and

investment

- considerations that should be taken into account when considering

entering into a tax treaty include the various features of tax treaties that

encourage and foster economic ties between countries, such as the

protection from discriminatory tax treatment of foreign investment that is

offered by the non-discrimination rules of Article 24, the greater certainty

of tax treatment for taxpayers who are entitled to benefit from the treaty

and the fact that tax treaties provide, through the mutual agreement

procedure, together with the possibility for Contracting States of moving

to arbitration, a mechanism for the resolution of cross-border tax disputes.

- Since one of the objectives of tax treaties is the prevention of tax

avoidance and evasion, States should also consider whether their

prospective treaty partners are willing and able to implement effectively

the provisions of tax treaties concerning administrative assistance, such

as the ability to exchange tax information and the willingness to provide

assistance in the collection of taxes would also be a relevant factor to

take into account. However, this could still be achieved by participation in

the multilateral Convention on Mutual Administrative Assistance in Tax

Matters. 183

183


53

In addition to the above, the OECD also noted that a State that may be

concerned that certain features of the domestic law of the State with which it is

negotiating may raise BEPS concerns or that changes that might be made after

the conclusion of a tax treaty and it may want to protect its tax base against

such risks. In such cases, the OECD suggests that it might be useful to include

in its treaties provisions that would restrict treaty benefits with respect to

taxpayers that benefit from certain preferential tax rules or with respect to

certain drastic changes that could be made to a country’s domestic law after the

conclusion of a treaty. 184 In this regard the OECD came up with certain

proposals on “special tax regimes” and also on ensuring that a tax treaty

responsive to certain future changes in a country’s domestic tax laws; to be

finalised in 2016.185

5 PREVENTING TREATY SHOPPING IN SOUTH AFRICA

The list of double tax treaties on the SARS’ website as at 31 March 2015 shows

that South Africa has entered into 75 double tax treaties, which have been

published in the Government Gazette, 21 of these DTAs are with African

countries. Another 36 treaties are in the process of negotiation or have been

finalised but not yet signed. The preamble to most of the double tax treaties

provides that the purpose of the treaties is “for the avoidance of double taxation

and the prevention of fiscal evasion with respect to taxes on income and on

capital”. Some of the DTAs merely have the object to avoid double taxation.186

5.1 THE STATUS OF DOUBLE TAX TREATIES IN SOUTH AFRICA

DTAs are international treaties and thus subject to international (public) law

rules regarding such treaties. Most of the customary rules of international law

concerning treaties are contained in the Vienna Convention on the Law of

Treaties.187 The Convention also contains new elements which aim to promote

the progressive development of international law.188 Whilst South Africa has not

signed the Vienna Convention, most of the rules contained in the Convention

will apply under South African law since they constitute customary rules of

184



See for example the DTAs with Germany, Austria and Denmark. 187

Vienna Convention on the Law of Treaties https://treaties.un.org/doc/Publication/UNTS/Volume%201155/volume-1155-I-18232-English.pdf.

188 R Lenz “The Interpretation of Double Taxation Conventions, General Report” Cahiers de

Droit Fiscal International Vo. XLII, 1960 at 294; Van Houtte “Auslengungsgrundsaetze im internen und im internationalen Steuerrecht in der Entwicklung des Steuerwesens seit dem ersten Weltkrieg“ IBFD, Amsterdam, 1968 at I1-41; DA Ward Principles to be applied in interpreting Tax Treaties“ IBFD Bulletin 1980 at 546-7.

54

international law 189 which must be applied by South African Courts in

accordance with section 232 of the Constitution, unless the rule is inconsistent

with the Constitution or an act of Parliament. Furthermore, in terms of section

231 of the Constitution, South Africa is bound by international agreements.190 If

a court is faced with the task of interpreting any provisions of a DTA, section

233 of the Constitution needs to be taken into account, which requires that

when interpreting any legislation, every court must prefer any reasonable

interpretation of the legislation that is consistent with international law over any

alternative interpretation that is inconsistent with international law.

International agreements do not form part of South African law unless a

legislative enactment gives the relevant provisions the force of law. This was

clearly stated by Chief Justice Steyn in Pan American Airways v SA Insurance

Co Ltd. He made the following remarks:191

"It is common cause, and trite law I think, that in this country the conclusion of a treaty,

convention or agreement by the South African government with any other government is

an executive and not a legislative act. As a general rule, the provisions of an international

instrument so concluded are not embodied in our municipal law except by legislative

process."

This is confirmed under section 231 of the Constitution. In terms of section

108(1) of the Income Tax Act, the National Executive may enter into DTAs with

the governments of other countries, whereby arrangements are made with a

view to the prevention, mitigation or discontinuance of the levying of tax in

respect of the same income, profits or gains or tax imposed in respect of the

same donation, or to the rendering or reciprocal assistance in the administration

of and the collection of taxes. Section 231 of the Constitution provides that a

treaty becomes part of South African law when it is approved by the National

Assembly and by the National Council of Provinces. As soon as the DTA is

approved by Parliament, it is required that notice of the arrangements made in

such an agreement be given by proclamation in the Government Gazette.192

The proclamation has the effect that the arrangements made by the DTA apply

as if they were enacted in the Income Tax Act.193

The question arises whether the provisions of a DTA can be overridden by

subsequent domestic legislation. Since DTAs form part of national law, the

normal rules of interpretation of statutes provide that subsequent legislation

189

Ibid. 190

Several of the South African DTAs have incorporated provisions contained in the United Nations Model DTA into the DTAs which means they may be somewhat different to the OECD Model DTA definition.

191 See also South Atlantic Inlands Development Corporation Ltd v. Buchan 1971 (1) SA 234

(C). 192

Sec 108(2) of the ITA. 193

Ibid.

55

which is contrary to a provision of the DTA may override the DTA provision.194

However, South African courts take judicial notice of international law.195 This

implies that the courts will ascertain and administer the appropriate rule of

international law as if it were part of South African law.196 This does not mean,

however, that the courts are bound to apply all rules of international law. In

accordance with the provisions of the Constitution and case law, international

law enjoys no privileged position in South Africa's legal system. 197

Nevertheless, a court must take notice of the requirement under section 231 of

the Constitution, i.e. that South Africa is bound by international agreements and

section 233 of the Constitution which requires that, when interpreting any

legislation, every court must prefer any reasonable interpretation of the

legislation that is consistent with international law over any alternative

interpretation that is inconsistent with international law.

Article 27 of the Vienna Convention on the Law of Treaties reads as follows:

"A party may not invoke the provisions of its national law as justification for its failure to

perform a treaty."

This rule is a well-established rule of international law. 198 The principle

expressed in this article is codified in article 26 of the Vienna Convention which

reads as follows: "Every treaty in force is binding upon the parties to it and must be performed by them in

good faith."

A State should thus abstain from acts calculated to defeat the object and

purpose of a treaty. Therefore, when a contracting State applies its domestic

anti-tax avoidance measures to deny DTA benefits to a resident of the other

contracting State, it may possibly contravene the basic prohibition under Article

27 of the Vienna Convention, particularly when it causes double taxation which

thus contravenes the main objective of a DTA.

However, Article 31(1) of the Vienna Convention determines that a treaty shall

be interpreted in good faith in accordance with the ordinary meaning to be given

to the terms of the treaty in their context and in the light of its object and

purpose. 199 Paragraph 2 defines the "context" for the purpose of

194

The lex posterior derogat priori rule – see L du Plessis Re-Interpretation of Statutes (2002) at73; also L Olivier Tax “Treaties and Tax Avoidance: application of anti-avoidance provisions; South Africa branch report” Cahiers IFA 2010 Congress in Rome at 724.

195 The Buchan case at 238.

196 Ibid.

197 The SA IFA Report at 723.

198 TO Elias “The Modern Law of Treaties” Leiden: Oceana Public (1974) at 45.

199 RG Wetze The Vienna Convention on the Law of Treaties edited by D Rausching,

Frankfurt: Alfred Metzner (1978) at 49; also the OECD Commentary on Article 1 of the OECD Model DTA, para 9.3 page 60; and the comments of Nathalie Goyette “Tax Treaty Abuse: A Second Look” Canadian Tax Journal Vol 51, no 2 (2003) at 768 where she remarks that “in light of the principle that States must execute a treaty in good faith, it is

56

interpretation. 200 Paragraph 3(a) and (b) specify that any subsequent

agreement between the parties regarding the interpretation of the treaty or any

subsequent practice in the application of the treaty which establishes the

understanding of the parties regarding its interpretation should be taken into

account when the treaty is interpreted. A third element which has to be

considered within the context is any relevant rules of international law

applicable in the relations between the parties (paragraph 3(c)). Paragraph 4

provides for the case where it is clear that the parties intended a term to have a

special meaning and not its ordinary (literal) meaning.

When the interpretation in terms of Article 31 leaves the meaning obscure or

ambiguous, or leads to a result which is manifestly absurd or unreasonable,

recourse may be had to supplementary means of interpretation, including the

preparatory work of the treaty and the circumstances of its conclusion201 (article

32).

Most of the rules of treaty interpretation contained in the Vienna Convention on

the Law of Treaties are, as pointed out, customary rules of international law.202

It is sometimes claimed that the "new" rules of interpretation included in the

Vienna Convention have also since acquired the status of customary rules of

international law.203 To the extent that this can be confirmed, the South African

courts would be required to apply these rules, but only to the extent that the rule

is not inconsistent with an act of Parliament.204

The application of these rules by a South African court can also be justified on

other grounds. A basic rule of interpretation under South African law is that

effect must be given to the intention of the legislature if this intention is clear.205

To establish the intention of the legislature, the surrounding circumstances

must be taken into account.206 The fact that a DTA is an international treaty

implies that its international nature should be taken into account by a South

African court when it has to establish the intention of the contracting

legitimate to doubt that the residents of those states are entitled to abuse the treaty in question.”

200 Vienna Convention on the Law of Treaties

https://treaties.un.org/doc/Publication/UNTS/Volume%201155/volume-1155-I-18232-English.pdf.

201 Wetzel The Vienna Convention on the Law of Treatiest.

202 Lenz at 294; Van Houtte at II-40-41; Ward at 546-7; Klaus Vogel Vogel on Double

Taxation Conventions 3rd Edition (1999) in para 28 at 21. 203

Vogel at 22. 204

As per section 232 of the Constitution. 205

Du Plessis at 102; See also T van Wyk Probleme by die uitleg van belastingwetgewing, LLM, Universiteit van Suid-Afrika, 31 Januarie 1975 at 83-84; T Van Wyk “Tax law: The interpretation of double taxation agreements” De Rebus Procuratoriis, (Jan. 1977) at 51.

206 Du Plessis,at 111; Bhana v Dönges 1950 4 SA 653 (A) at page 662D – 667H; Van Wyk,

Probleme, at 84 -85.

57

governments. 207 This implies that the agreement should have the same

meaning in South African law as it has in international law.208

The rules of interpretation contained in the Vienna Convention place emphasis

on the textual or formalistic approach but considerable scope is left for the

application of the teleological approach. 209 This implies that the ordinary

meaning of a treaty term is not to be determined in the abstract, but in the light

of the object and purpose of the treaty as a whole.210 Furthermore, subsequent

practice of the contracting States can modify provisions of the treaty.211 It also

sanctions the ambulatory approach, i.e. the interpreter may take the evolution

of the laws of the contracting States into account, provided the change in the

national law of a respective State does not defeat the object and purpose of the

treaty. 212

The Appellate Division of the Supreme Court considered the interpretation of a

tax treaty in the case of Secretary for Inland Revenue v Downing. 213 The

respondent left South Africa in 1960 to live in Switzerland. Apart from an

allowance of R20 000, he was not permitted to take his assets with him. The

balance of his assets consisted of a large share portfolio which he entrusted to

a broking member of the Johannesburg Stock Exchange to manage. The basic

issue before the Court was whether or not the respondent had carried on

business in South Africa "through a permanent establishment situated therein",

within the meaning of Article 7(1) of the DTA between South Africa and

Switzerland. Article 7(1) of the treaty reads as follows:

"The profits of an enterprise of a Contracting State shall be taxable only in that State,

unless the enterprise carries on business in the other Contracting State through a

permanent establishment situated therein. If the enterprise carries on business as

aforesaid, the profits of the enterprise may be taxed in the other State but only so much

of them as is attributable to that permanent establishment."

The Court acknowledged that the terms of the DTA are based upon the OECD

Model DTA of 1963. It was further recognised that this model served as the

basis for the network of DTAs existing between this country and other

countries. It did not indicate, however, to what extent it regarded the OECD

Commentary as binding on South African courts. The lower Court did, however,

207

Van Wyk, Probleme at 84. 208

Ibid. 209

Schwarzenberger International Law vol. I, 3rd Edition (1957) at 492-493. 210

Ibid; also see Wetzel at 49. 211

Ibid. 212

Ibid; also see the criticism of Vogel in para 125b at 66, that a contracting state should not introduce domestic rules to circumvent its DTA obligations, for example, the introduction of the Secondary Tax on Companies by South Africa which replaced the non-resident shareholders tax could be regarded as such an instance since the new tax was no longer covered by older South African DTAs as confirmed in Volkswagen case.

213 1975 (4) SA 518 (A).

58

base its argument on a passage from the OECD Commentary.214 To interpret

the relevant DTA terms, the court first considered the definitions of the relevant

terms in the DTA. The appellant's counsel argued that the terms of the

definition of "permanent establishment" (Article 5 of the DTA) should be

narrowly construed, i.e. since the first two requirements (Article 5(1), read with

Article 5(2)(c)) of the definition had been fulfilled, the respondent fell within the

ambit of the permanent establishment concept. The Court rejected this

approach and pointed out that Article 5 must be read as a whole. It expressed

the opinion that such an interpretation would make Article 5(5) redundant which

could not have been the intention of the contracting parties. In determining the

meaning of the words "acting in the ordinary course of their business" (see

Article 5(5)), the Court stressed that the words should be ascribed their natural

meaning. It came to the conclusion that the respondent did not fall within the

ambit of the permanent establishment concept.

The approach adopted by the Court corresponds with the guidelines for

interpretation contained in the Vienna Convention, although no reference was

made in the decision to those guidelines. This approach was subsequently

applied in ITC 1503215 where the Court considered the OECD Commentary and

then concluded that the income in question should be treated as ancillary to the

main stream of income, as suggested by the OECD Commentary.

The courts have since often applied the OECD Commentary and other

international guidelines in considering cases involving DTAs.216 In CSARS v

Tradehold Ltd,217 the Court made the statement that a DTA overrides domestic

law: “Double tax agreements effectively allocate taxing rights between the contracting states

where broadly similar taxes are involved in both countries. They achieve the objective of

s 108, generally, by stating in which contracting state taxes of a particular kind may be

levied or that such taxes shall be taxable only in a particular contracting state or, in some

cases, by stating that a particular contracting state may not impose the tax in specified

circumstances. A double tax agreement thus modifies the domestic law and will apply in

preference to the domestic law to the extent that there is any conflict.”218

214

See page 526 of the case report. 215

(53) SATC 342, at 349. 216

See the decisions in CSARS v Tradehold Ltd (132/11) [2012] ZASCA 61; Oceanic Trust 2012 74 SATC 127; also the UK High Court decision Ben Nevis (Holdings) Limited and Another v CHMRC [2013] EWCA Civ 578 which considered a request by SARS for the assistance by the HMRC under the UK/South Africa DTA to collect taxes due by a resident of South Africa.

217 (132/11) [2012] ZASCA 61

218 CSARS v Tradehold Ltd; Ibid in para 17.

59

5.2 TREATY SHOPPING IN SOUTH AFRICA

There is no case law in South Africa on issues pertaining to treaty shopping that

can be used to give an indication as to whether treaty shopping is a major

BEPS concern for South Africa. An indication of the scale of treaty shopping

could be determined by considering aggregate statistics on foreign direct

investment (FDI). However, even with statistics on FDI, it is difficult to

distinguish indirect investment through intermediaries from direct investment,

and even more difficult to separately identify cases involving indirect investment

for tax planning purposes. Moreover, the use of intermediaries may involve tax

planning other than treaty shopping. Nevertheless, a comparison of FDI and

trade data, and an understanding of the domestic tax and treaty policies of

those countries that rank among the largest in terms of FDI in South Africa, can

provide circumstantial evidence about the scale of treaty shopping. 219 In

general, high levels of inbound and outbound FDI can be an indicator that a

country commonly serves as a conduit investment country. 220 However, indirect

investment is not always driven by treaty shopping; it may reflect other

objectives of a multinational enterprise.

5.2.1 TREATY SHOPPING: REDUCING SOURCE TAX ON DIVIDENDS,

ROYALTIES AND INTEREST WITHHOLDING TAXES

A number of withholding taxes have been introduced in South Africa.221 It is

hoped that these will be instrumental in eliminating base erosion. However,

these withholding taxes (generally at a uniform rate of 15%) are more effective

when the non-resident's country of residence does not have a double tax treaty

with South Africa. Where a double tax treaty exists, the rate at which

219

OECD “Tax Conventions and Related Questions: Written Contributions from Members of the Focus Group on Treaty shopping”(2013) in para 2.

220 Ibid.

221 The following withholding taxes apply in South Africa.

- The interest withholding tax; levied in terms of section 50A-H of the Act at a rate of 15% with effect from 1 March 2015 in respect of interest that is paid or becomes due and payable on or after that date.

- The dividend withholding tax levied in terms of section 64D – N of the Act, introduced from years of assessment commencing 1 April 2012 at a rate of 15%.

- The withholding tax on royalties (which was historically levied under repealed section 35(1) of the Act at a final rate of 12%), now levied at a rate of 15% in terms of section 49A – G of the Act with effect from 1 January 2015 in respect of royalties that are paid or become due and payable on or after such date;

- The withholding tax on foreign entertainers and sportspersons which is levied at a rate of 15% in terms of section 47A – K of the Act, with effect from 1 August 2006;

- The withholding tax on the disposal of immovable property by non-resident sellers levied in terms of section 35A of the Act, at a rate of 5% if the non-resident is an individual, 7.5% if the non-resident is a company and 10% if the non-resident is a trust with effect from 1 September 2007;

For a detailed discussion of South Africa's withholding tax regime please refer to: AW Oguttu "An Overview of South Africa's Withholding Tax Regime" TaxTalk (March/April 2014).

60

withholding taxes may be levied by South Africa as the source country is

usually limited, as there is a requirement that a treaty state entity has a PE in

South Africa before South Africa has any rights to levy any tax. Most of South

Africa's DTAs, based on the OECD MTC do not contain favourable withholding

tax rates for South Africa. This puts South Africa in a vulnerable position as in

some cases the withholding tax is zero. With the predominantly uniform

domestic rate of 15% now in place, the DTAs to which South Africa is party,

require renegotiation. The potential for treaty shopping has now become more

significant for South Africa, especially with the introduction of the new

withholding taxes on dividends and interest. In particular, the risk of conduit

companies being used as a means of reducing South African withholding taxes

can be significant.

A foreign company carrying on business operations through a South African

subsidiary can reduce the Dividends Withholding Tax (DWT),(61) imposed (at a

statutory rate of 15%) in South Africa on dividend distributions by the subsidiary

to its parent company, by using a treaty shopping scheme. For example, if the

investment is channeled through an intermediate holding company (Dutch

Holdco) established in the Netherlands, the Dutch/South African DTA will

function to limit the DWT tax to 5%.222

With proper construction, the dividends should qualify for the Dutch

participation exemption for foreign dividends and the net dividend income (a

small margin is required in the Netherlands) could also be extracted from the

Netherlands without any Dutch withholding tax. The Dutch/South African DTA

will also function to reduce the withholding tax on interest (IWT) from 15% to

0%. Therefore, the ultimate investor could loan funds to the Dutch Holdco,

which would on-lend the funds to the South African subsidiary, thus avoiding

the IWT. The Netherlands does not impose any withholding tax on interest paid

to a non-resident, subject to rather generous thin capitalization restrictions, i.e.

again requiring a small margin for Dutch Holdco.

The Dutch/South African DTA will also function to reduce the withholding tax on

royalties (RWT) from 15% to 0%. Therefore, the ultimate investor could license

the supply of intellectual property (IP) to the Dutch Holdco, which would sub-

license the use of the IP to the South African subsidiary, thus avoiding the

RWT. The Netherlands does not impose any withholding tax on royalties paid

to a non-resident and merely requires a small margin for Dutch Holdco.

The benefits of a DTA could also be accessed by a non-resident on a

temporary basis by ceding the right to the income to a company in a country

222

Article 10(2) of the DTA – provided the Dutch Holdco held at least directly or indirectly 25% of the voting power in the company paying the dividends.

61

which has a beneficial DTA with South Africa, before such income accrues to

the non-resident cedent. For example, a right to royalties, dividends or interest

could be ceded to such a resident of the other contracting state, thus potentially

qualifying for the benefits of that DTA at the time when such income accrues.223

In the case of dividends, it may be difficult to ensure qualification for the

particular requirements under the typical DTA, for example, the requirement

that the intermediary holding company needs to hold at least 10% of the shares

in the South African company. However, even this could be temporarily

manipulated to ensure the required shareholding at the point in time when the

dividend is declared, with the subsequent redemption of the additional shares

acquired merely for this purpose.

The total tax burden on such dividends, interest and royalties could thus be

reduced significantly through the treaty shopping scheme.

It is however worth noting that South Africa is taking measures to adopt its tax

treaty negotiation policy to cater for the new policy on withholding taxes.

Currently, all DTAs with zero rates are under renegotiation so that they are not

used for treaty shopping purposes. It should however be noted that, in practice,

the process of negotiating or renegotiating DTAs is long.

It is recommended that when re-negotiating the new limits for treaty

withholding tax rates, caution is exercised since high withholding taxes

can be a disincentive to foreign investment. Equilibrium must be

achieved between encouraging foreign investment and protecting South

Africa's tax base from erosion.

5.2.2 TREATY SHOPPING: ACCESSING CAPITAL GAINS BENEFITS

A resident of a country which has no DTA or a less beneficial DTA with South

Africa could make an investment in a property holding company in South Africa

via a country, such as the Netherlands, in order to protect the eventual capital

gains realized on the sale of the shares from South African capital gains tax.

Treaties based on the OECD MTC provide in article 13(4) that the Contracting

State in which immovable property is situated may tax capital gains realised by

a resident of the other State on shares of companies that derive more than 50

per cent of their value from such immovable property. 224 However in Article

13(4) of the Dutch/South African DTA, only the Netherlands may impose tax on

the gains realized from the sale of shares in a South African company. The

Dutch/South African DTA does not follow the OECD MTC in this regard, unlike

the US South African DTA, which allows South Africa to impose tax on such

223

See the example of such arrangements in the OECD Report on Abuse, para 42 at 15. 224


62

gains if the South African property company derives 50% or more of its value

from immovable property. In the Netherlands, the gain on the sale of the shares

should enjoy the protection under the Dutch participation exemption, and it is

possible to extract the gain from the Dutch intermediate company without

incurring withholding tax.

A resident of a country that has no DTA with South Africa could use a treaty

shopping scheme to obtain the benefit of the limitation of South African tax by

the "permanent establishment" concept (see further discussion below). It could,

for example, create a conduit company in Switzerland and channel its South

African activities through this company to enjoy the protection from South

African tax offered by the permanent establishment provisions under the

Swiss/South African DTA.

As discussed above, the OECD Final Report on Action 6 recommends

schemes to take advantage of capital gains benefits should be curtailed if

countries ensure that they sign article 13(4) of the OECD Model Convention,

which is an anti-abuse provision that allows the Contracting State in which

immovable property is situated to tax capital gains realised by a resident of the

other State on shares of companies that derive more than 50 per cent of their

value from such immovable property.225 Paragraph 28.5 of the Commentary on

Article 13 provides that States may want to consider extending the provision to

cover not only gains from shares but also gains from the alienation of interests

in other entities, such as partnerships or trusts, which would address one form

of abuse.

The OECD noted that Article 13(4) will be amended to include such

wording. 226

In cases where assets are contributed to an entity shortly before the sale

of the shares or other interests in that entity in order to dilute the

proportion of the value of these shares or interests that is derived from

immovable property situated in one Contracting State. The OECD noted

that Article 13(4) also will be amended to refer to situations where shares

or similar interests derive their value primarily from immovable property

at any time during a certain period as opposed to at the time of the

alienation only. 227


the envisaged multilateral instrument under Action 15, which will alleviate

the need to renegotiate all its double tax treaties to cover these changes.

225




63

5.2.3 SCHEMES TO CIRCUMVENT DTA LIMITATIONS

(a) Using the "dual residence" concept

The concept of "dual residence" can be used to avoid the DWT. Many countries

regard a company as resident in their territory if it is managed and controlled

there, whereas other countries consider the place of incorporation of a

company as a factor determining its residence. It is thus possible that a

company can be regarded as a "resident" of both contracting States in terms of

the general definition of a "resident" under the domestic laws of the respective

contracting states which definition is usually confirmed in the DTA. DTAs

generally solve such cases of "dual residence" by providing that such a

company shall be deemed to be resident in the contracting State in which its

place of effective management is situated.228

If a company incorporated in South Africa is effectively managed in the United

Kingdom (UK), it will be deemed to be a resident of the UK for purposes of the

DTA between South Africa and the UK. A UK resident parent company can thus

avoid South African DWT on dividends derived from its South African subsidiary

by transferring the effective management of the subsidiary to the UK. The

subsidiary will then be treated as a UK tax resident which is not subject to DWT

in terms of section 64C of the ITA.

Nevertheless, that subsidiary will incur a CGT exit tax in South Africa in terms

of section 9H of the ITA and paragraph 12(2)(a) of the Eighth Schedule to the

ITA which provides that when a South African tax resident ceases to be a tax

resident by virtue of the application of the provisions of a tax treaty entered into

by South Africa with another jurisdiction, the resident must, subject to certain

exclusions, be treated as having disposed of all his/her assets. The provision

would for instance apply if a company moves its place of effective management

out of South Africa.




It should also be noted treaty abuses relating to dual resident entities will

also be dealt with in light of that the OECD recommendation that the

current POEM rule found in Article 4(3) will be replaced with a case-by-

case solution of these cases. 230 The competent authorities of the

Contracting States shall endeavour to determine by mutual agreement

the Contracting State of which such person shall be deemed to be a

228

See Article 4(3) of the UK/South Africa DTA. 229



64

resident for the purposes of the Convention, having regard to its POEM

the place where it is incorporated and any other relevant factors. In the

absence of such agreement, such person shall not be entitled to any

treaty benefits. 231

South Africa can adopt this change in its tax treaties if it signs the

multilateral instrument envisaged under Action 15, which will alleviate the

need to renegotiate all double tax treaties.

Using the Permanent Establishment Concept

The "permanent establishment" concept in DTAs functions to limit the source

tax liability of a resident of one contracting State, who carries on business in the

other contracting State. South African DTAs generally provide that an

enterprise of one contracting State will not be taxed on business profits derived

from the other contracting State, unless that enterprise carries on business in

the other State through a permanent establishment situated therein. Therefore,

if a resident of a State that has concluded such a DTA with South Africa carries

on trading activities in South Africa, without establishing a fixed place of

business in South Africa, the income derived will not be subject to South African

tax by virtue of the DTA.

The permanent establishment concept in most South African DTAs does not

include a building site or construction or assembly project if the project does not

exist for more than twelve months (in some DTAs, e.g. the DTA with Israel, the

period is limited to six months). A resident of those contracting States will,

therefore, not be subject to South African tax on building or construction

activities if the specific project does not last longer than twelve months (six

months for residents of Israel).

A resident of the other contracting state could split up the project into different

parts, which are performed by different legal entities, thus allowing the fuller

project to be performed in South Africa without incurring a tax liability in South

Africa.

In the context of e-commerce, a resident of the other contracting state could

conduct fully fledged sales activities in South Africa via a website without

creating a permanent establishment in South Africa, provided the enterprise

operates via a server based outside South Africa or an independent server

based in South Africa.

It should be noted that treaty abuse through splitting-up of contracts to

take advantage article 5 of the OECD Model Convention and the e-

231


,

65

commerce concerns 232 will also be curtailed by the OECD

recommendation that the Principle Purpose Test rule that will be added to

the model convention in terms of the OECD Report on Action 7

(Preventing the Artificial Avoidance of Permanent Establishment Status,

2015).233

Concerns about renegotiating all its tax treaties will be alleviated if South

Africa signs the envisaged multilateral instrument under Action 15.

It should also be noted that, in the case of AB LLC and BD Holdings Tax,234 the

Tax Court ruled that a service PE had been created in light of article 5 of the

South African/USA DTA. The facts of the case were that a USA company

provide strategic and financial services in South Africa whereby its employees

occupied the board room at the recipient’s premises to conduct those services.

The company’s employees spent a period exceeding 183 days in South Africa.

The Commissioner assessed the company for income earned from the services

rendered on the basis that the company operated from a PE as contemplated in

article 5(2)(k) of the DTA which included in the meaning of a PE the furnishing

of services, including consultancy services, by an enterprise through employees

if the activities continue (for the same or a connected project) for an aggregate

period of more than 183 days in any twelve-month period. The court ruled that

since the company provided consulting services through its employees in South

Africa for a period exceeding 183 days, a PE had been created. Even article

5(1) of the DTA could be applied in that boardroom where the services were

performed constituted a fixed place of business. So the income earned by the

company was attributable to that PE and taxable in South Africa.

(a) Artificial Arrangements Qualifying for Reduced Rates

The DTAs generally contain provisions which function to reduce an exposure to

withholding taxes in the source country if the resident of the other contracting

state qualifies under certain criteria, e.g. that the latter should hold at least 10%

of the capital of the company in the source state to qualify for the reduced DTA

rate of 5% (from 15% in other cases). The resident of the other contracting

state could arrange for a temporary increase in its shareholding, e.g. by taking

up additional shares in the company in the source state (if there is no PE

established there)235, shortly before a dividend declaration (in respect of the

ordinary shares) which shares are then redeemed shortly after the dividend

declaration. This could thus secure a 10% saving.

232



Tax Court Case number 13276 February 2015. 235

Unless article 10(4) of the OECD MTC applies.

66

The above transactions can also be curtailed by the recommendation in OECD

Final Report on Action 6 regarding specific treaty provisions to deal with

circumstances where taxpayers get involved in dividend transfer transactions,

whereby a taxpayer entitled to the 15 per cent portfolio rate of Article 10(2)(b)

may seek to obtain the 5 per cent direct dividend rate of Article 10(2)(a) or the 0

per cent rate that some bilateral conventions provide for dividends paid to

pension funds.236 The concern is that Article 10(2)(a) does not require that the

company receiving the dividends to have owned at least 25 per cent of the

capital for a relatively long time before the date of the distribution. This may

encourage abuse of this provision, for example, where a company with a

holding of less than 25 per cent has, shortly before the dividends become

payable, increased its holding primarily for the purpose of securing the benefits

of the provision, or where the qualifying holding was arranged primarily in order

to obtain the reduction. 237

The OECD concluded that in order to deal with such transactions, a

minimum shareholding period before the distribution of the profits will

be included in Article 10(2)(a).

Additional anti-abuse rules will also be included in Article 10 to deal

with cases where certain intermediary entities established in the State

of source are used to take advantage of the treaty provisions that

lower the source taxation of dividends.238


the envisaged multilateral instrument under Action 15, which will

alleviate the need to renegotiate all its double tax treaties to cover

these changes.

5.2.4 TREATY SHOPPING IN SOUTH AFRICA’S PREVIOUS TREATY WITH

MAURITIUS

South African investors have used Mauritius as a vehicle for investing in other

countries with which Mauritius has treaties. Likewise, international investors

from other countries that have tax treaties with Mauritius have used Mauritius

as an intermediary to invest in South Africa.

The first tax treaty between South Africa and Mauritius came into force in 1960,

through the South Africa/United Kingdom tax treaty, which was extended to

Mauritius. During that time, Mauritius was still a colony of the United Kingdom.

It is important to note that even though Mauritius gained its independence from

the UK in 1968, the above-mentioned tax treaty was still applicable to Mauritius

until termination in 1997 with the coming into force of a new tax treaty in 1997,

236




67

directly between South Africa and Mauritius. However South Africa signed a

new treaty with Mauritius on 17 May 2013. The South African Parliament

ratified the treaty on 10 October 2013. Mauritius ratified the new treaty on 28

May 2015. In terms of section 108 of the Income Tax Act No 58 of 1962 (Act),

on 17 June 2015, the treaty was published in the Government gazette (GG

38862). The new South Africa-Mauritius tax treaty, entered into force on 28 May

2015, and replaces the 1996 South Africa-Mauritius tax treaty.

The main reason for the signing of the new tax treaty was due to perceived

“abuse” of the 1997 tax treaty, and resultant erosion of the South African tax

base. The World Bank and the International Finance Corporation have

consistently ranked Mauritius as one of the best Sub-Saharan African countries

in which to do business. The main drivers are that Mauritius:

Is a member of SADC, WTO and COMESA.

Has a vast network of treaties with countries. It is party to 35 double

taxation agreements.

has no capital gains tax.

has a low corporate income tax rate at 15%, which translates into an

effective tax rate of 3% after taking into account available credits.

(GBL1 gets up 80% credit while GBL2 qualifies for exemption).

The Economic Perspective

From an economic perspective, South Africa is, today, a major trade and

economic partner of Mauritius. South Africa invests heavily in various sectors of

the Mauritian economy such as banking and finance, retail, ICT, real estate,

manufacturing, agribusiness as well as logistics. South Africa’s foreign direct

investment (FDI) into Mauritius over the past six years has grown significantly,

making South Africa the largest single foreign investor after the United

Kingdom.

Graph 1 below regarding current trade and values between South Africa and

Mauritius shows that import values from Mauritius have ranged from R538m in

2008 to R1,719m in 2012 (CAGR of 36% ), while export values have ranged

from R3,041m in 2008 to R2,305m in 2012 (CAGR of -6%). While exports have

shown negative growth in the years 2008 to 2012, they are still well above our

imports from the region (R2,305m exports in 2012 vs. R1,719m imports in

2012). Below is SA-Mauritius Trade Balance.

68

Graph 1

(Source: Finweek 27 May, 2013)

Graph 2 below shows the investment flows between South Africa and Mauritius.

Graph 2

(Source: Finweek 27 May, 2013)

South Africa’s FDI flows into Mauritius have been steadily increasing while

Mauritius’ flows into South Africa have been flat in the period 2006 to 2009.

This is indicative of the ease of doing business as well as the attractiveness of

the Mauritius tax regime. However, with the new treaty, these flows could

reverse as it will not be beneficial for South African companies to use Mauritius

as a gateway for Sub-Saharan African expansion.

Graph 3 below shows that although foreign direct investment into Mauritius has

been volatile over the last few years, finance and insurance has seen significant

growth in investment. Accommodation and Food has been declining while

Construction has seen tremendous growth off a low base. Real Estate

investment growth is testimony to Mauritius being a tourist destination. This

2008 2009 2010 2011 2012

Exports (Rm) 3 041 2 329 2 318 2 182 2 305

Imports (Rm) 538 557 708 1 142 1 719

0

500

1 000

1 500

2 000

2 500

3 000

3 500

SA-Mauritius Trade Balance

2006 2007 2008 2009

Flows to Mauritius (Rbn) 35.5 35.1 46.8 53.5

Flows from Mauritius (Rbn) 6 5.1 6 5.9

0

10

20

30

40

50

60SA-Mauritius Investment Flows

69

mirrors South African company investments in Mauritius as indicated in

Appendix A to this document. The fallout of the euro zone's financial troubles

had a negative impact on flows to the Indian Ocean Island, resulting in an

inbound flow of 9.46 billion in 2011 from 13.9 billion rupees a year earlier.

Conditions improved during 2012 with direct investments totalling 12.7 billion

Rupees. Mauritius is shifting from an economy traditionally focused on sugar,

textiles and tourism towards offshore banking, business outsourcing, luxury real

estate and medical tourism. From the graph below, it can be observed that the

largest investments are made in Real Estate (est.40%) and Finance and

Insurance (est.34%) activities.

Graph 3

Source: Bank of Mauritius (Provisional)

Statistics from the Bank of Mauritius as indicated in graph 4 below show that

South Africa is the 2nd largest investor in Mauritius (2,797 million rupees = 22%)

behind the UK. From the analysis of investments by South Africa in Mauritius, a

robust growth trend can be observed. The magnitude of foreign investment

growth into Mauritius by South Africa is well pronounced post the 2008/2009

financial crisis.

2006 2007 2008 2009 2010 2011 2012

Construction 12 45 68 211 1292 2094 1775

Accommodation and Food 1382 3189 1348 1850 836 579 645

Finance and Insurance 3593 4056 4564 1371 4645 1646 4348

Real Estate 1701 3820 4525 4305 3422 4580 5122

Health and Social Work 2 29 120 145 2732 0 0

0

1000

2000

3000

4000

5000

6000

Ru

pe

es

(M

illio

n)

Foreign Direct Investment by Major Sector

70

Graph 4

Source: Bank of Mauritius (Provisional)

The tax perspective

Putting the above statistics into a tax context, the high FDI flows into Mauritius

point to Mauritius being an enabler for arbitrage opportunities. This was

encouraged by both its business-friendly environment as well as lower tax rates

for offshore companies. Tax credits of up 80% for GBL1 (Global Business

Licence) companies are available. Aslo GBL2 companies can invoke tax

exemptions. Putting the above FDI flows into context, below is a discussion as

to how South African residents make use of treaties Mauritius has signed for

treaty shopping purposes.

The Mauritius/India Tax Treaty – Sale of Shares Taxable only in

Shareholder Country

South African residents wishing to invest in India often take advantage of the

Mauritius/India treaty by routing investments via Mauritius in order to gain tax

advantages. In terms of the South Africa/India treaty (and most other treaties

with India) capital gains derived from the sale of shares in a company may be

taxed in the country in which the company whose shares are being sold is a

resident (i.e. in India), and since India has a tax on capital gains the gain does

not escape taxation. In short, where a South African company invests directly

into India it will be subject to CGT on the sale of the shares in the Indian

company.

To avoid such taxation, South African investors route investments via Mauritius

by setting up a GB1 company in Mauritius which takes advantage of the

2006 2007 2008 2009 2010 2011 2012

Flows from SA to Mauritius 38 498 1415 510 1468 2169 2797

Flows from Mauritius to SA 14 35 20 70 325 49 77

0

500

1000

1500

2000

2500

3000R

up

ee

s (M

illio

n)

SA-Mauritius FDI

71

provisions in the Mauritius/India treaty, which provides that capital gains arising

from the sale of shares are taxable only in the country of residence of the

shareholder and not in the country of residence of the company whose shares

are being sold. As a result, a company resident in Mauritius selling shares of an

Indian company will not pay tax in India on the disposal of the Indian company’s

shares. Since there is no capital gains tax in Mauritius, the gain will escape tax

altogether. The capital gain can then be repatriated back to the South African

shareholder free of withholding taxes as Mauritius does not levy tax on

dividends, interest or royalties for GBL1 companies.

Mauritius/African Tax Treaty Network – Lower Withholding Tax Rates

South African companies often route investments into other Africa countries via

Mauritius since Mauritius has negotiated better benefits in its tax treaties with

some African countries than South Africa has. This is especially so with regard

to withholding tax rates (on dividends, interest, royalties and

management/technical fees) in treaties between Mauritius and other African

countries, which are generally lower than the withholding tax rates in tax

treaties between South Africa and other African countries.

Avoiding South African Dividends Tax

Hypothetical example: South Africa imposes a dividends tax at a rate of 15% on

dividends paid by a company which is tax resident in South Africa (SACo) to its

holding company (HoldCo) that is tax resident in a “tax favourable” non-treaty

country (Country A). Country A however has a treaty with Mauritius, which in

turn has a treaty with South Africa. In terms of the Mauritius SA treaty, South

Africa is prohibited from imposing dividends tax in excess of 5% where the

beneficial owner of the shares in SACo is a company which is tax resident in

Mauritius and the beneficial owner owns more than 10% of the shares in the

SACo.

HoldCo establishes a company in Mauritius (SubCo) that, in terms of the

domestic law in both Country A and Mauritius is tax resident in Mauritius.

HoldCo is able to demonstrate that the place of effective management of

SubCo is not South Africa. HoldCo disposes of the shares in SACo to SubCo.

By virtue of having moved the ownership of SACo to Mauritius, HoldCo is able

to reduce the SA dividends tax burden by two thirds. This is because Mauritius

imposes local corporate tax in respect of the dividends received from SACo, so

no or little Mauritian tax would be payable because of its foreign tax credit

regime.

No dividends tax withholding regime applies in Mauritius. It is open for South

Africa to challenge whether SubCo is truly the “beneficial owner” of the shares.

http://en.wikipedia.org/wiki/Capital_gains_tax

72

While Mauritius is used in this example, any other jurisdiction providing for a

similar reduction in dividends tax rate could have been chosen (keeping in mind

that many of those jurisdictions would themselves have a dividends tax

withholding regime which would negate the benefit of any treaty shopping).

However, it may be that a country has a dividends tax withholding regime but,

because of specific provisions in its domestic tax law or its general corporate

law, the dividends tax withholding regime does not apply. For example,

notwithstanding that the Netherlands has a dividends tax withholding regime

and foreign dividends constitute taxable income, the domestic law regards

distributions from certain legal entities, such as the Dutch Co-Operative entity,

as not being subject to the dividends tax regime. Thus, the dividends derived

from SACo would be exempt from tax in the Netherlands in terms of its

participation exemption. The Netherlands could work just as well as Mauritius,

but for a different reason.

Avoiding Other Withholding Taxes

A similar approach could be adopted in relation to royalties (and interest and

services once the withholding taxes become effective in South Africa). For

example, Cyprus would be a good jurisdiction to divert royalties to as the

withholding tax rate is reduced to 0% where the beneficial owner is resident in

Cyprus. Once again South Africa would need to challenge the nature of the

ownership of the Cyprus intermediate holding company that is in receipt of the

relevant royalties.

Capital Gains Tax (CGT) Carve-Out for Property Rich Companies

Mauritius and the Netherlands are jurisdictions through which many inbound

investments flow into South Africa. This is especially so in circumstances where

investment funds are routed towards acquiring ownership of South African

immovable property. The reason for this is that the current treaties239 that South

Africa has a treaty with Netherlands that provides protection against a South

African CGT charge on companies based in Netherlands which own shares in a

South African company holding immovable property. This was the case also in

Mauritius’s previous treaty with South Africa – but the treaty was renegotiated

as is discussed before, so this matter is no longer a concern in this treaty.

In terms of the Eighth Schedule to the Income Tax Act,240 non-residents are

subject to CGT when they dispose of immovable property, an interest in

immovable property, or assets of a permanent establishment 241 located in

South Africa. An interest in immovable property includes shares or trust

239

These treaties are not based on the more robust/fair OECD Model Tax Conventions. 240

To the Income Tax Act, 1962. 241

Par 2(1) of the Eighth Schedule.

73

interests where more than 80% the market value of such share or trust interest

is attributable to the immovable property (so-called “property rich companies”).

It should be noted that immovable property includes not only land and buildings,

but also mineral rights and improvements which accede to the land (such as

happens with redraftable energy projects).

Many inbound foreign direct investments are planned in advance for an exit

with the time horizon being as short as five years. Investments are therefore

structured to ensure a CGT free exit, particularly where a good portion of the

management fees charged by the foreign investor to the local company are

embedded within the eventual selling price (“the free carry”). As a result, many

companies, lately also those investing in renewable energy projects, routed

their investments into South Africa via Mauritius or the Netherlands242 to avoid

the CGT cost.

It should, however, be noted that the CGT carve-out was removed from the new

treaty between South Africa and Mauritius.243 The capital gains Article of the

new treaty now specifically provides that a country may tax gains derived from

the alienation of shares deriving more than 50% of their value directly or

indirectly from immovable property situated in such country. The treaty between

South Africa and the Netherlands still contains a CGT carve-out clause, and

therefore continues to pose a source of possible leakage to the fiscus.

Aspects of the new Mauritius/South Africa treaty designed to prevent treaty

abuse

The new treaty between Mauritius and South Africa applies to normal tax, to

withholding taxes on royalties and on foreign entertainers and sportsmen and

the secondary tax on companies (which has been abolished). Although

dividends tax has not been expressly included in Article 2 of the new treaty,

Mauritius has been advised by SARS that it will form part of the treaty, which

Mauritius has implicitly accepted.

(a) Mutual agreement on residence

242

The relevant clause (article 13(4)) of the Netherlands treaty reads as follows: “Gains from the alienation of any property other than that referred to in paragraphs 1, 2 and 3, shall be taxable only in the Contracting State of which the alienator is a resident.” There is a school of thought to suggest “immovable property” as envisaged by article 6(2) of the Netherlands treaty (see below) would include the expanded definition of immovable property as envisaged by par 2(2) of the 8

th Schedule. It is however generally accepted

the meaning refers to the general meaning of immovable property under our law and not the par 2(2) meaning.

243 The renegotiated treaty has been signed, and has been ratified in South Africa but not yet

in Mauritius.

74

The most significant change brought about by the new treaty concerns

companies that are tax resident in both Mauritius and South Africa. In terms of

the OECD Model Tax Convention tie breaker rules, double taxation of dual

residents companies is resolved by ensuring that the company is tax resident in

the State in which its “place of effective management” is situated. A South

African incorporated company which is effectively managed in Mauritius would

thus, in terms of the OECD tie breaker rules, be deemed to be tax resident in

Mauritius and South Africa would lose its "taxing rights”. One of the perceived

“abuses” of the 1997 Mauritius/South Africa treaty is by companies incorporated

in Mauritius that purport to be effectively managed there, but are in fact run

from South Africa. That is the case where significant functions that benefit the

Mauritian company’s operations take place in South Africa.

Under the new treaty the dual-residence tiebreaker rules provide that the

competent authorities of the two states shall endeavour to determine, by mutual

agreement, the Contracting State of which such person shall be deemed to be

resident for the purposes of the treaty. This “mutual agreement procedure” as a

manner for determining the tax residence status of a taxpayer is contemplated

by the commentary on Article 4 of the OECD Model Tax Convention and, as

discussed above, supported by the discussion in Action 6 of the BEPS Action

Plan.

The alternative provision provides that, in endeavouring to come to agreement

on where the taxpayer shall be deemed to be resident, regard must be had to

its place of effective management, the place where it is incorporated or

otherwise constituted and any other relevant factors. Where it is clear as to

where the company is in fact effectively managed, such a provision would bring

about no change. Accordingly, companies that are currently incorporated in

Mauritius and are clearly managed there will not be affected by this provision. In

a case where both South Africa and Mauritius believe that a company is

incorporated in and purportedly effectively managed in Mauritius, and is also

managed in South Africa, South Africa may wish to assert that the company is

resident in South Africa. Unless South Africa and Mauritius can agree on where

the company is resident, it will be a resident, for treaty purposes, of both

countries and taxable in both countries. The contracting states are not required

to grant the dual resident entity treaty benefits.

There is no obligation on the competent authorities to reach an agreement on

the residency of an entity and it is probably practical to assume that the

chances are remote of reaching agreement swiftly or even at all. The

competent authority of Mauritius, for example, would, in principle, not have an

active interest in coming to a mutual agreement where this would involve losing

its taxing rights to South Africa. The fate of a dual resident company is that

there is the potential for it to suffer tax in both countries but the effect of this

75

could be ameliorated by any applicable domestic exemptions or credits (such

as section 6quat). However, because Mauritius is a low tax jurisdiction,

domestic relief for foreign tax paid is unlikely to offset the disadvantage of being

subject to tax in both states (especially in light of the repeal of the tax sparing

clause).

The practical effect of the above is that the dual resident company could be

denied the benefits of the treaty and be subject to double taxation in South

Africa and Mauritius if no agreement is reached between the two contracting

states regarding the residence of the company. A binding arbitration process as

per the current provisions of the OECD is not applicable under the proposed

treaty.

Some consequences of the new treaty are:

It may force companies to stop creating dual residence situations. The

new treaty will necessitate taxpayers to relook at their position as it

places the onus on them to ensure that they structure effective

management and substance of their entities so as to avoid double

taxation. Since the Mauritian tax rates are lower than those in South

Africa, it could imply that South African companies will also be unable to

benefit from the section 6quat rebate if effective management is deemed

to be in South Africa. The double taxation impact could result in

decreased South African FDI into Mauritius – albeit minimal.

The new treaty widens South Africa’s tax net as it increases South

Africa’s ability to identify Mauritian companies that should be regarded

as resident here, given the way in which they in fact operate.

The new treaty may also help to bring into the tax net certain Mauritian

branches of South African companies, in that, if the branch houses the

company’s only activity, it may be possible to claim that the company is

dual resident by virtue of incorporation in South Africa and effective

management in Mauritius.

The new treaty does not affect Mauritian companies that clearly have

their effective management in Mauritius.

(b) Withholding rates

Interest: Under the old treaty, interest paid out of South Africa to a Mauritian

beneficial owner would not be taxable in South Africa. Under the new treaty, the

amount that South Africa is able to withhold on interest paid to a Mauritian

beneficial owner has increased from nil to 10% of the gross amount of the

interest. Mauritius does not currently impose a withholding tax on interest paid.

South African lenders to Mauritian borrowers would thus not be negatively

affected by the amendment of the interest article, while on the other hand

Mauritian lenders to South African borrowers would be affected.

76

Dividends: In terms of the new treaty, dividends tax will be withheld at a 10%

rate unless the beneficial holder of the dividend holds at least 10% of the capital

of the company paying the dividends, in which case the tax will be 5%.

Royalties: In terms of the new treaty, the amount that South Africa is able to

withhold on royalties paid to Mauritius has increased from nil to 5%. The above

withholding tax rates will have an impact on Mauritian financing or IP licensing

entities that derive Interest or royalty income from South Africa.

(c) Capital Gains Tax (CGT) Carve-Out for Property Rich Companies

As noted above, apart from being a low tax jurisdiction in which to operate,

Mauritius has also been a favourable base for investing into South African land

rich companies. The new treaty provides that capital gains earned by Mauritian

tax residents could be subject to South African CGT if the gain is from the

disposal of shares in a South African company holding immovable property - a

“land rich” company. This will have an impact on Mauritian companies that

currently hold South African based investments in the mining or property sector.

Thus the capital gains article of the new treaty repeals the so called “CGT cut

out” clause as it specifically provides that a country may tax gains derived from

the alienation of shares deriving more than 50% of their value directly or

indirectly from immovable property situated in that country.

However, this gives rise to the potential for investors to channel this type of

investment through companies in other countries that still have a treaty with

South Africa that still have CGT cut out clause. This was the case for example

with South Africa/Netherlands treaty. Note however that the South

Africa/Netherlands DTA has been renegotiated and is awaiting signature. This

matter is also of concern in the South Africa/Luxembourg DTA. It is also worth

noting that the South Africa/Austria DTA and 18 other DTAs that have a zero

rate on interest and/or royalties and those that do not have 13(4) of OECD are

under renegotiation. These renegotiations will ensure that changes in

ownership of shares in Mauritian land rich companies prevent the incentive to

change the ownership to residents in other treaty countries now that there is

South African CGT on disposal.

(d) Tax Sparing

The new treaty no longer includes a tax sparing clause. Rather, it allows for

relief in the form of a foreign tax credit.

(e) Exchange of information on tax matters and assistance in the collection of

taxes

77

The 1996 tax treaty had a limited version of exchange of information provision

that did not extend to bank secrecy. The new tax treaty contains the latest

OECD standard for the exchange of taxpayer information on tax matter as set

out in article 26 of the OECD MTC. This will assist in the auditing of South

African residents domiciled in Mauritius. The treaty also contains provision

relating to assistance in tax collection of taxes.

(f) Remarks and Recommendations

There is no doubt that the new treaty will put Mauritian companies in a less

beneficial position vis-à-vis South Africa than is currently the case. This is so,

specifically in the context of dual-resident companies, loans to South African

borrowers, and investments in companies owning immovable property in South

Africa. However, this does not necessarily mean that the use of Mauritian

companies is no longer beneficial in international structures. The other concern

is that MNE are now more likely to prefer being based in Mauritius (for example

manufacturing companies) instead of being based in South Africa.

It should be noted that treaty shopping can never be entirely stamped out and

the chances are that some multinationals may look to other tax treaties to avoid

having to pay CGT. One must bear in mind that the withholding taxes in the

new treaty are still lower than the normal South African holding tax rate. Where

there is an entity in a third country either from which the Mauritian incorporated

dual resident entity is receiving payments or to which it is making payments,

being a dual resident could offer the advantage of the ability to cherry pick

treaty rates.

The dual resident company may thus be able to avail itself of either the tax

treaty that South Africa has with a third country or the tax treaty that Mauritius

has with the third country. In these circumstances, since the “mutual agreement

procedure” has to be initiated by the taxpayer, where the taxpayer takes

advantage of other treaties, it would be difficult for such a taxpayer to initiate

the mutual agreement procedure. In the absence of a specific fact scenario it is

difficult to predict the extent to which the ability of a dual resident to “cherry

pick” could lead to revenue leakage for South Africa, but it is a matter to be

borne in mind during future risk profiling of Mauritian structures.

As noted above, the withholding tax rates provides in the new treaty are still

lower than the normal South African withholding tax rates. Although

headquarter companies enjoy exemptions from withholding taxes, headquarter

companies cannot be used for investment into South Africa. Foreign investors

would thus still prefer investing into South Africa via Mauritius, or they could

look for another suitable jurisdiction to act as holding company jurisdiction for

investment into Africa, including South Africa.

78

5.2.5 TREATY SHOPPING: SOUTH AFRICA’S TREATIES ENCOURAGING

DOUBLE NON-TAXATION

(a) The Treaty with Switzerland

An example of double non-taxation has arisen in the context of the previous

treaty between Switzerland and South Africa. In particular, that treaty provided

for relief in respect of double taxation by way of exemption. It stated as follows: “Where a resident of a Contracting State derives income…which, in accordance with

the provisions of this Convention, may be taxed in the other Contracting State, the first-

mentioned State shall exempt such income from tax…”

In terms of this arrangement if Switzerland had, and exercised, its right to tax

certain income, South Africa was obliged to exempt that income from tax.

Switzerland offered various beneficial effective tax rates in respect of, inter alia,

financing transactions. Transactions existed where South African companies

operated through permanent establishments in Switzerland. Substantially all the

income of the entity was attributable to the permanent establishment and

Switzerland exercised its taxing rights in respect of the income.

However, the effective rate in Switzerland was often as low as approximately

1.5%. In terms of the previous treaty between South Africa and Switzerland;

South Africa was then required to exempt these amounts from tax. This

resulted in non-taxation due to the low effective rate applied in Switzerland. The

previous treaty was re-negotiated and now provides a tax credit for foreign tax

suffered by South African residents in Switzerland.

(b) The Treaty with Zambia

The treaty between South Africa and Zambia provides taxing rights to Zambia

in respect of interest paid on certain debt instruments advanced by South

African residents. South Africa may not tax such interest.

In circumstances where interest is tax deductible in terms of South

African domestic law. There is no requirement that such amounts be

taxed in the other jurisdiction in terms of the OECD Model Tax

Convention.

There is also no “subject-to-tax” clause in respect of such amounts in

terms of South African domestic tax law.

This is one of the oldest DTAs in South Africa’s network (it came into

operation in 1956) was first renegotiated in 2002 and was finalised in

December 2010. The treaty is now awaiting signature.

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The above matter should be considered by the South African tax authorities at

the time of entering into treaties with other jurisdictions.

South Africa entered into treaties with, inter alia, Ireland, Belgium and

Luxembourg, which jurisdictions have provisions effectively mitigating

the quantum of tax paid in those jurisdictions. For example, an investor

may set up a Luxembourg company and invest in equity in that company

in the form of redeemable preference shares. The Luxembourg entity

may then advance a loan to the South African entity. As a matter of

Luxembourg tax law a deduction will be granted for the dividends

payable in respect of the redeemable preference shares, leaving the

Luxembourg entity taxable only on its spread/margin. Belgium has a

similar provision. Ireland merely taxes at a low rate.

In this regard there is significant competition for tax revenues on a world-

wide basis. Jurisdictions are incentivised to enter into as many treaties

as possible and then also to offer tax incentives, inter alia, to attract

multi-nationals into their jurisdictions.

South Africa is one such jurisdiction. For example, South Africa

introduced the headquarter company regime in terms of which foreign

investors may invest through South Africa into, inter alia, Africa. As part

of marketing this initiative South Africa has made mention of its many

treaties with African jurisdictions. In particular South Africa competes

directly with Mauritius in respect of attracting foreign investment into

Africa. Unfortunately there have been uncertainties regarding South

Africa’s headquarter company regime and it has not been very attractive

as the Mauritius one, despite South Africa’s extensive treaty network.

5.2.6 TREATIES WITH TAX SPARING PROVISIONS

To encourage foreign investment, developing countries often grant fiscal

incentives to foreign investors.244 When countries sign a double tax treaty, and

an investor from the developed country is offered a tax incentive by the

developing country, the tax incentive may be eliminated or reduced by the tax

regime of the investor’s country. 245 This often occurs where the investor’s

country applies the credit method to prevent the double taxation of income. In

reaction to this possibility, some double tax treaties preserve the benefit of

source country tax incentives through “tax sparing” provisions, in terms of which

developed countries amend their taxation of foreign source income to allow

244

A Easson Tax Incentives For Foreign Direct Investment (2004) 1-2; JR Hines “Tax Sparing and Direct Investment in Developing Countries” in Hines JR International Taxation and Multinational Activity (2001) 40; D Holland & R Vann “Income Tax Incentives for Investment” in V Thuronyi Tax Law Design and Drafting (1989) 986.

245 Hines at 40.

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their residents, who invest in developing countries to retain the tax incentives

provided by those countries.246

In effect, tax sparing provisions preserve the tax incentive granted by the

developing country by requiring the developed country to give a tax credit for

the taxes that would have been paid to the developing country if the incentive

had not been granted.247 Tax sparing has, however, become rather unpopular

and several developed countries have become restrictive in including tax

sparing provisions in their tax treaties.248 It is reasoned that tax sparing may not

be that instrumental in promoting foreign investment and that it encourages

abusive tax practices.249

Tax sparing also encourages “treaty shopping”. 250 This is mainly done by

interposing a “conduit company”251 in one of the contracting states so as to shift

profits out of those states.252 Generous tax sparing credits in a particular treaty

can encourage residents of third countries to establish conduit entities in the

country granting the tax incentive.253

The OECD set out the following best practice guidelines for countries for

drafting tax sparing provisions: (a) Tax incentives should be precisely defined to refer to specific incentives so as to

prevent open-ended tax sparing that encourages abusive practices.254

(b) Tax sparing should ideally be restricted to local as opposed to export activities.255

(c) A maximum tax rate should be set for tax sparing credits to prevent the artificial

increase of the rates.256

(d) Anti-abuse clauses should be included to prevent abusive practices.257

(e) Time limitations or sunset clauses should be included, so that the provision is not

indefinitely used for abusive practices. 258

(f) Tax sparing should ideally be restricted to business income rather than passive

income. This would discourage harmful tax practices involving geographically

246

Hines at 40; R Rohatgi Basic International Taxation (2002) 213. 247

AW Oguttu “The Challenges of Tax Sparing: A Call to Reconsider the Policy in South Africa” Bulletin for International Taxation (2011) (Vol 65) No 1 in para 2; K Brooks “Tax Sparing: A Needed Incentive for Foreign Investment in Low-Income Countries or an Unnecessary Revenue Sacrifice?” (2008-2009) 34 Queen’s Law Journal 508.

248 V Thuronyi “Recent Treaty Practice on Tax Sparing” (2003) 29 Tax Notes International

301. 249

BJ Arnold & MJ McIntyre MJ International Tax Premier 2ed (2002) at 52-53. 250

H Becker & FJ Wurm Treaty Shopping: An Emerging Tax Issue and its Present Status in Various Countries (1988) 1; S Van Weeghel The Improper Use of Tax Treaties with Particular Reference to the Netherlands and The United States (1998) 119.

251 A Rappako Base Company Taxation (1989) 16.

252 Ibid.

253 Arnold & McIntyre at 53.

254 OECD Tax Sparing: A Reconsideration (1998) at 35-36.

255 OECD Tax Sparing Report at 36-37.

256 Ibid.

257 Ibid.

258 OECD Tax Sparing Report at 37-38.

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mobile activities. 259

Since tax sparing provisions are difficult to design and they often create

undesirable and unintended economic and fiscal effects, 260 the OECD

recommends that countries follow the form in Annex VI of the OECD Report on

Tax Sparing when designing their tax sparing provisions.

As a member of the South African Development Community (SADC), South

Africa espouses the recommendations of the Memorandum of Understanding

(MOU) on Co-operation in Taxation and Related Matters among SADC

countries,261 which encourages member states to include tax sparing provisions

in their tax treaties so as to promote foreign investment. However, in paragraph

2 and 3 of article 23 of the SADC Model, South Africa has reserved its right not

to provide tax sparing. Although, South Africa previously stated, in its OECD

non-member country position, that it reserves the right to add tax sparing

provisions in its treaties with regard to the tax incentives provided for under its

laws, since the 2008 version of the OECD MTC, South Africa removed its

reservation on tax sparing and it no longer includes tax sparing in its treaties.

South Africa’s Model Treaty does not cover tax sparing provisions.262 Before,

this new position on tax sparing was taken, South Africa had concluded 16 tax

treaties with tax sparing provisions. The first one was with Israel in 1979, then

Romania, Thailand, Mauritius, Ireland, Egypt, Pakistan, Tunisia, Algeria,

Uganda, Greece, Seychelles, Botswana, Ethiopia, Brazil and the last one with

Mozambique, came into force in 2009, although negotiations of the same were

completed in 2002.263 Since then South Africa no longer includes tax sparing in

its DTAs.

The tax sparing provisions in the treaties with Thailand (1996), Egypt (1999),

Tunisia (1999), Pakistan (1999), Uganda (2000), Algeria (2001) and Greece

(2003) have reciprocal tax sparing provisions. The terms are that: an investor’s

state of residence allows an exemption against tax due on the tax which the

state of source could have imposed, even if the source state has waived all or

part of that tax under its tax incentive laws that promote economic

development.264 Notably, these provisions are too widely drafted as they do not

refer to any specific tax incentive but to all “laws designed to promote economic

259

OECD Tax Sparing Report at 36 and 43. 260

International Chamber of Commerce. 261

SADC “Memorandum of Understanding on Cooperation in Taxation and Related Matters” (art 4). Retrieved June 25 2009 from http://www.sadc.int/index/browse/page/167

262 Olivier & Honiball at 334; Oguttu “The Challenges of Tax Sparing: A Call to Reconsider

the Policy in South Africa” in para 7.2. 263

SARS “Comprehensive Treaties in Force”. Retrieved June 7 2010 from http://www.sars.gov.za/home.asp?pid=391931983 dd 13/03/2009

264 Oguttu “The Challenges of Tax Sparing: A Call to Reconsider the Policy in South Africa” in

para 7.2; Olivier & Honiball at 334.

http://www.sadc.int/index/browse/page/167

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development in that Contracting State”.265 Furthermore, these provisions have

no time limits and nor do they contain anti-abuse clauses that can be applied to

prevent tax abuse.

The tax sparing provisions in the 1995 treaty with Romania and the (now re-

negotiated) 1997 treaty with Mauritius have a much wider scope than the ones

mentioned above. These two provisions, worded in almost a similar manner,

extend the tax sparing provision not only to “laws designed to promote

economic development … effective on the date of entry into force” of the treaty

but also to “provisions which may be introduced in future in modification of, or in

addition to, the existing laws”.266 The tax sparing provision in the treaty with

Romania further extends this wide scope in that it refers not only to “laws

designed to promote economic development” but also to laws designed to

promote “decentralization”.267

The tax sparing provisions in the relatively newer treaties with Seychelles (late

2003), Botswana (2004), Ethiopia (2006) and Mozambique (2009), are limited

to schemes for the promotion of economic development that have been

mutually agreed upon by the competent authorities of the Contracting States. It

is important to note that when agreeing to tax sparing South Africa retained the

right to reach mutual agreement in respect of the economic development

schemes before allowing tax sparing to operate. Indeed, no schemes have

ever been agreed with any of these countries with which mutual agreement is

required. 268 Although the competent authorities have the power to settle the

mode of application of the tax sparing provisions and thus limit their scope,

these provisions still fall short of the OECD recommendations in that they lack

sunset and anti-abuse clauses.

There are also some obsolete tax sparing provisions, such as the one in the

1979 treaty with Israel (which refers to tax holiday scheme for new investments

in terms of 37H of the Income Tax Act, 269 which was abolished on 30

September 1999). The other obsolete tax sparing provision is in the 1997 treaty

with Ireland which referred to the now defunct Undistributed Profits Tax.270

265

E.g art 23(2) of the South African/Algeria treaty. Government Gazette 21303 dd 21/06/2000.

266 Art 23 (2) of the South Africa/Mauritius treaty. Government Gazette 18111 dd 02/07/1997.

267 Art 23(3) of the South Africa/Romania treaty. Government Gazette 16680 dd 27/09/1995.

268 Oguttu “The Challenges of Tax Sparing: A Call to Reconsider the Policy in South Africa” in

para 7.2; Olivier & Honiball at 335. 269

Introduced s 12(1) of Revenue Laws Second Amendment Act 46 of 1996. 270

Oguttu “The Challenges of Tax Sparing: A Call to Reconsider the Policy in South Africa” in para 7.2; Deneys Reitz “Editorial comment: Tax-sparing Clauses” Integritax (Dec 1998) 1.

83

The treaty with Brazil: This treaty has a tax sparing provision in respect of

government bonds. Article 11(1) of the treaty between South Africa and Brazil

provides that interest arising in a Contracting State and paid to a resident of the

other Contracting State may be taxed in that other State. However, Articles

11(4)(a) and (b) provide that notwithstanding the provisions of paragraphs 1

and 2: “(a) interest arising in a Contracting State and derived and beneficially owned by the

Government of the other Contracting State, a political subdivision thereof, the

Central Bank or any agency (including a financial institution) wholly owned by that

Government or a political subdivision thereof shall be exempt from tax in the first-

mentioned State;

(b) subject to the provisions of subparagraph (a), interest from securities, bonds or

debentures issued by the government of a Contracting State, a political

subdivision thereof or any agency (including a financial institution) wholly owned

by that government or a political subdivision thereof, shall be taxable only in that

State”.

Article 11(4)(b) read with Article 11(4)(a) of the treaty therefore applies, inter

alia, to provide exclusive taxing rights to Brazil in respect of interest derived

from bonds issued by the Brazilian government and derived and beneficially

owned by South African residents other than the South African government,

South African Reserve Bank or other governmental agencies set out in Article

11(4)(a) of the treaty.

Recommendations on Tax Sparing

It is acknowledged that tax treaties are not generally negotiated on tax

considerations alone and often countries’ treaty policies take into

account their political, social and other economic needs.271 Nevertheless,

care should be taken to adhere to international recommendations when

designing tax sparing provisions, so as to prevent tax abuse. The OECD

recommends that such designs should follow the form set out in its 1998

Report on Tax Sparing.

The problem in the older treaties may be resolved by renegotiation of the

treaty or through a protocol. The protocol should, for instance, ensure

that the relevant tax sparing provision refers to a particular tax incentive

and should contain a sunset clause or expiry date to ensure that it is not

open to abuse.272

As the process of removing or modifying existing tax sparing provisions

to prevent such abuses is often slow and cumbersome,273 South Africa’s

legislators should ensure that future tax sparing provisions are drafted

circumspectly.

271

Weeghel at 257-260. 272

RJ Vann & RW Parsons “The Foreign Tax Credit and Reform of International Taxation” (1986) 3(2) Australian Tax Forum 217.

273 Para 76 of the OECD commentary on art 23A & 23B.

84

It is thus desirable for South Africa to adhere to the OECD’s

recommendations and best practices in drafting tax sparing provisions.

All the obsolete tax sparing provisions should be brought up to date with

the current laws if they are still considered necessary.

5.2.7 ISSUES PERTAINING TO MIGRATION OF COMPANIES

In the case of CSARS v Tradehold Ltd, 274 a South African company was

“migrated” to Luxembourg from a tax perspective. This had the effect of capital

gains which had accumulated in the company during the period that it was a

resident of South Africa being taxable only in Luxembourg. Luxembourg then

did not exercise its domestic tax law to tax any such gain. As a result of the

decision in this case, South Africa’s domestic law was amended in order to

prevent such arrangements. Specifically, section 9H of the Income Tax Act

states that, inter alia, where a company that is a resident ceases to be a

resident, or a controlled foreign company ceases to be a controlled foreign

company, the company or controlled foreign company must be treated as

having disposed of its assets on the date immediately before the day on which

that company so ceased to be a resident or a controlled foreign company, for

an amount equal to the market value of its assets.




5.2.8 ISSUES PERTAINING TO DIVIDEND CESSIONS

Shortly after the introduction of dividends tax in section 64D of the Income Tax

Act, various transactions were entered into by non-resident shareholders of

South African shares in order to mitigate the tax. In particular, non-resident

shareholders of listed South African shares in respect of which dividends were

to be declared transferred their shares to South African resident corporate

entities. The dividends were therefore declared and paid to the South African

resident corporate entities which claimed exemption from dividends tax on the

basis that, as set out in section 64F(1) of the Income Tax Act, the entities

constituted companies which were residents of South Africa.

o The South African resident corporate entities then paid “manufactured

dividend” or other derivative payments to the non-resident. These

payments did not constitute dividends and were therefore not subject to

the dividends tax.

o The South African resident corporate entities therefore received

dividends which were not exempt from normal tax, but in respect of

274 (132/11) [2012] ZASCA 61. 275

OECD/G20 2015 Final Report on Action 6 in para 65-66.

85

which they obtained a tax deduction for the “manufactured dividend”

payments made to the non-resident shareholder.

o The non-resident shareholder received amounts that did not constitute

dividends and therefore did not attract any dividends tax.

o The provisions of section 64EB of the Act were therefore introduced in

August 2012. These provisions have subsequently been updated. The

provisions adequately deal with such transactions since, inter alia; they

deem the “manufactured dividend” payments to constitute dividends

which are liable for dividends tax.

o A variation on this transaction is the transfer of the shares to an entity

situated in a jurisdiction which has a treaty with South Africa that reduces

dividends tax from the domestic rate of 15% to 5%. It is also envisaged

that similar transactions will be entered into in respect of debt

instruments now that the interest withholding tax has been imposed from

1 March 2015. The recommendation in respect of applying the GAAR

and including anti-tax-avoidance language in the relevant treaties should

be considered in respect of these transactions.

5.2.9 BASE EROSION RESULTING FROM EXEMPTION FROM TAX FOR

EMPLOYMENT OUTSIDE THE REPUBLIC

Section 10(1)(o)(ii) of the Income Tax Act, exempts from tax any remuneration

received or accrued by an employee by way of any salary, leave pay, wage,

overtime pay, bonus, gratuity, commission, fee, emolument, including an

amount referred to in paragraph(i) of the definition of gross income (fringe

benefits):

For a period exceeding 183 full days in aggregate during any 12 month

period commencing or ending during that or any other year of assessment

For a continuous period of 60 days during such the 12 months period.

If such services were rendered during such periods worked outside the

Republic. Provided that days in transit in the Republic are deemed to be

outside the Republic. Days on holiday outside of the Republic count

towards the number of days required.

Section 10(1)(o) was implemented along with the residence basis of taxation in

2001. It was supposed to be reviewed after 3 years. More than ten years have

passed without a review. The concern about the provision is that there are

many South Africans working abroad but whose home is still South Africa, so

the exemption takes away the right for South Africa to tax on a residence basis.

Because of the section 10(1)(o) exemption, an SA resident individual working in

a foreign tax free country will not pay tax anywhere in the world on his/her

remuneration for services rendered if he/she meets the 183 day (broken) and

86

60 day (continuous) outside SA requirements per tax year. At present it is not

clear as to how many taxpayers are taking advantage of the exemption. SARS

does not have reliable statistics on this matter.

In a double tax treaty context, article 15 of treaties based on the OECD MTC

deals with income from employment. The article provides that:

(a) Salaries, wages and other similar remuneration derived by a resident

of one state in respect of an employment are subject to tax in that

state only, unless the employment is exercised in the other state, in

which case the remuneration derived from the other state may be

taxed in that state.

(b) Notwithstanding the general rule described in (a), remuneration

derived by a resident of one state in respect of an employment

exercised in the other state may be taxed in the state of residence

only if three conditions are met:

(i) the recipient is present in the state in which he or she is not

resident for a period or periods not exceeding in the aggregate

183 days in any twelve-month period commencing or ending in the

fiscal year concerned;

(ii) the remuneration is paid by or on behalf of an employer who is

not a resident of the state in which the recipient is not resident;

and

(iii)the remuneration is not borne by a permanent establishment

which the employer has in the state in which the recipient is not

resident.

It is recommended that either:

the exemption should be withdrawn and a foreign tax rebate

granted if foreign tax is imposed on the basis that the ongoing

income stream should be taxable in RSA, even if the capital is

invested abroad. or

the exemption is amended to only apply where the employee will

be taxed at a reasonable rate in the other country.

5.2.10 BASE EROSION RESULTING FROM SOUTH AFRICA GIVING AWAY

ITS TAX BASE

Some foreign jurisdictions, especially in Africa, are incorrectly claiming source

jurisdiction on services (especially management services) rendered abroad and

yet those services should be considered to be from a South African source.

These foreign jurisdictions are withholding taxes from amounts received by

South African residents in respect of services rendered in South Africa. The

withholding taxes are sometimes imposed even if a treaty that exists between

South Africa and the foreign country specifies otherwise, in that the treaties do

87

not have an article dealing with management fees or South African residents

have no permanent establishments in these countries. This results in double

taxation.

In South Africa, the source of income from services is where the services are

rendered rather than the quarter from which the service fees are received, as

was held by the Appellate Division in the Lever Brothers case. Where double

taxation arises, there is no foreign tax credit available to provide relief for

taxpayers. This has made South Africa unattractive as a headquarter

location.276 Taxpayers can only claim a deduction of the foreign tax in the

determination of taxable income in accordance with section 6quat(1C).

However, this deduction only gives partial relief and is therefore insufficient to

fully alleviate double taxation. 277

In 2011, a special foreign tax credit for service fees was introduced to operate

as some form of a relief from double or potential double taxation on cross-

border services for South African multinational companies that render services

to their foreign subsidiaries. This foreign tax credit applied to foreign withholding

taxes imposed in respect of service fees from a South African source (i.e.

services rendered in South Africa by a South African resident to a foreign

resident). The special tax credit applied on an income-by-income basis.

National Treasury noted that section 6quin was intended to be a temporal

measure aimed at addressing interpretation issues arising out of three DTAs

where the treaty partners did not apply the provisions of the DTAs in respect of

services rendered by SA residents in those countries. Nevertheless this

temporary measure could be interpreted that SA had departed from the tax

treaty principles in the OECD MTC in its treaties with African countries, in that it

gave them taxing rights over income not sourced in those countries. As a

result, South Africa effectively eroded its own tax base as it was obliged to give

credit for taxes levied in the paying country.

In the 2015 Tax Laws Amendment Act the section 6quin special foreign tax

credit was withdrawn with effect from 1 January 2016.278 National Treasury’s

reason for the change was that the special tax credit regime was a departure

from international tax rules and tax treaty principles in that it indirectly

subsidised countries that do not comply with the tax treaties.

South Africa was the only country in the world that provided for this kind of tax

concession. This provision effectively encouraged its treaty partners not to

abide by the terms of the tax treaty in respect of the taxation of fees and thus

276

PWC “Comments on DTC BEPS First Interim Report” (30 March 2015) at 22. 277


Section 5 of the Draft Taxation Laws Amendment Bill 2015.

88

give them taxing rights over income that is not sourced in those countries.

Consequently, it defeated the whole purpose of the tax treaty.

While the enactment of this relief was well intended, it resulted in a significant

compliance burden on the South African Revenue Service. Some taxpayers

also exploited this relief by claiming it even for other income such as royalties

and interest that are not intended to be covered by this special tax credit.279

Mutual Agreement Procedure (MAP) under tax treaties is the forum that ought

to be used to solve such problems.

There have been concerns that withdrawal of section 6quin could undermine

South Africa as a location for headquarters and could see banking, retail, IT

and telecommunication companies which could end up relocating their service

centers elsewhere. The tax credit under section 6quin was reasoned to be one

of the reasons why such service companies based their headquarters in South

Africa.280 Its removal could lead to increased project costs for local service

providers due to double taxation; which would impact on their cash flow.281 This

could compel such companies to move their management centers to lower tax

jurisdictions. Alternatively, such costs could be cut by relocating skilled personal

into other African countries, which is now considered rather than deal with the

tax issues in South Africa.

In order to mitigate against such concerns and any double taxation that could

be faced by South African taxpayers doing business with the rest of Africa,

section 6quat(1C) Income Tax Act has been amended to allow for a deduction

in respect of foreign taxes which are paid or proved to be payable without

taking into account the option of the mutual agreement procedure under tax

treaties. All tax treaty disputes should be resolved by competent authorities of

the respective countries through mutual agreement procedure available in the

tax treaties as a mechanism to resolve disputes. Section 6quat(1C) previously

stated that: “For the purpose of determining the taxable income derived by any resident from carrying

on any trade, there may at the election of the resident be allowed as a deduction from the

income of such resident so derived the sum of any taxes on income (other than taxes

contemplated in subsection (1A) proved to be payable by that resident to any sphere of

government of any country other than the Republic, without any right of recovery by any

person other than a right of recovery in terms of any entitlement to carry back losses arising

during any year of assessment to any year of assessment prior to such year of

assessment”.

279

Explanatory Memorandum to the Taxation Laws Amendment Bill, 2015. 280

BusinessDay “MTN Warns Against Removing African Tax Incentive”. Available at http://www.bdlive.co.za/business/technology/2015/09/17/mtn-warns-against-removing-african-tax-incentive accessed 21 October 2015.

281 BusinessDay “MTN Warns Against Removing African Tax Incentive”. Available at

http://www.bdlive.co.za/business/technology/2015/09/17/mtn-warns-against-removing-african-tax-incentive accessed 21 October 2015.





89

In terms of the Taxation Laws Amendment Act 2015, the amended s

6quat(1C)(a) provision which came into effect from 1 January 2016 reads:

‘‘For the purpose of determining the taxable income derived by any resident from

carrying on any trade, there may at the election of the resident be allowed as a

deduction from the income of such resident so derived the sum of any taxes on income

(other than taxes contemplated in subsection (1A)) paid or proved to be payable by that

resident to any sphere of government of any country other than the Republic, without

any right of recovery by any person other than in terms of a mutual agreement

procedure in terms of an international tax agreement or a right of recovery in terms of

any entitlement to carry back losses arising during any year of assessment to any year

of assessment prior to such year of assessment”.

In terms of SARS Interpretation Note 18, the phrase “proved to be payable”

should be interpreted as an "unconditional legal liability to pay the tax."

The concern though is whether the deduction method is a feasible approach

that will offer taxpayers relief. The word “paid" as used in the section could be

interpreted as requiring an "unconditional legal liability to pay the tax". If so,

there would be no relief in cases where tax is incorrectly withheld (e.g. contrary

to treaty provisions).

To avoid such a situation, it is recommended that the wording in the

previous 6quin, should be reintroduced in section 6quat1(C) which gives

access to the section if tax was "levied" or "imposed" by a foreign

government.

It is submitted that the rationale behind the introduction of section 6quin

remains valid; in that it was intended to make South Africa an attractive

as a headquarter location. However this does not detract from the fact

that it resulted in the erosion of its own tax base.

South Africa’s need to develop a coherent policy in respect of treaty

negotiation and interpretation, especially with respect to its response to

Africa’s needs. SARS is encouraged to actively engage with the African

countries which are incorrectly applying the treaties with the objective of

reaching agreement on the correct interpretation and application of the

treaties. South African taxpayers should not be subjected to double

taxation simply because SARS is not able to enforce binding

international agreements with other countries.282

South African has a model tax treaty which informs its treaty

negotiations. This model treaty should be made publicly available and

any treaties that provide for the provision of taxing rights on technical

service fees should be renegotiated insofar as possible to bring them in

line with the model in this regard. 283

282


PWC “Comments on DTC BEPS First Interim Report” (30 March 2015) at 22.

90

As noted above, the Mutual Agreement Procedure (MAP) under tax

treaties is the forum that ought to be used to solve problems arising from

the improper application of the treaty, such as in this case, where treaty

services rendered by South African residents in treaty countries ought to

be taxed in South Africa but those countries still impose withholding

taxes on services rendered in these countries despite the fact that the

DTAs with these countries do not have an article dealing with

management fees or South African residents have no permanent

establishments in these countries. MAP has however not been effective

in Africa.

It is recommended that solving this problem, that is affecting intra-Africa

trade, will require organisations such as ATAF to play a significant role.

5.2.11 TREATY SHOPPING THAT COULD BE ENCOURAGED BY SOUTH

AFRICA’S HEAD QUARTER REGIME

South Africa has a Head Quarter Company (HQC) regime under section 9I and

several other relevant provisions284 of the ITA. The objective of the HQC regime

is to allow non-residents to establish a holding company in South Africa which

would be used to make acquisitions in other countries, i.e. to promote the use

of South Africa as the base for holding international investments.

The South African tax impact of the regime is that a HQC will be able to earn

dividends, interest, royalties and realisation gains from its foreign investments

without incurring any South Africa tax on the flow of such items of income into

and out of South Africa to the ultimate third party beneficiaries. This is

achieved as follows:

Dividends derived by a HQC from its equity investments in foreign

companies should qualify for the exemption under section 10B(2) of

the ITA, since it needs to hold at least 10% of the equity shares and

voting rights in the foreign company to qualify.

Dividends declared by a HQC will be exempt from dividends

withholding tax (“DT”) in terms of section 64E(1) of the ITA.

Interest derived by a HQC from loans advanced to the foreign

companies will be subject to normal tax. However, the HQC should

be entitled to deduct the interest expense incurred in respect of loans

raised to advance such loans to the foreign companies since the

HQC is not subject to the transfer pricing (including thin

capitalisation) restrictions under section 31 of the ITA. Therefore, any

284

Sec 9(2)(d) read with sec 35, sec 9D, sec10B, sec 31, section 37K and par 64B(2) of the ITA.

91

such loans could be arranged on a back-to-back basis to avoid any

tax liability for the HQCs.285

In should be noted that in terms of the current version of section 23M, which was introduced with effect from 1 January 2015, a HQC is not excluded from its scope, which may then apply to restrict the interest deduction. It is, however, expected that this will be amended as it was not the intention to subject the HQC to tax on such interest earned from its foreign acquisitions. In the same vein it is necessary that HQCs are exempted from s 8F and s 8FA.

In terms of section 20C of the ITA, the interest deduction will be ring-

fenced to the interest earned on foreign loans. Therefore, to the

extent that there is a margin between the incoming interest and the

payment of interest, the difference will be taxed in South Africa.

However, no margin is required.

The HQCs will be exempt from the interest withholding tax (IWT

The royalties derived by the HQCs from the foreign companies would

be subject to South African tax but the corresponding royalties paid

to the non-resident owner of the IP would be tax deductible. In terms

of section 49D(b), royalties paid by a HQC are not subject to the

withholding tax on royalties. Therefore, the non-resident owner of the

IP could licence the right to use the IP to the HQC which would sub-

licence the use to the foreign companies without incurring any South

African tax. Since the transfer pricing rules would not apply, no

margin would be required.

In terms of paragraph 64B(2) of the Eighth Schedule to the ITA, a

HQC must disregard any capital gain or capital loss in respect of the

disposal of any equity share in any foreign company, provided the

HQC held at least 10% of the equity shares and voting rights in that

foreign company. The shares to be acquired by the HQCs should be

regarded as capital investments (as opposed to trading stock), which

means that the realisation gains would be of a capital nature, subject

to the provisions of the Eighth Schedule to the ITA. Therefore, the

realisation gains would not be subject to tax and no DT would be

imposed on the distribution of such gains.

The HQC will thus be subject to tax by virtue of its incorporation in

South Africa, but the various exemptions from withholding taxes and

the transfer pricing rules should have the impact that the HQC would

not effectively be subject to any tax. Nevertheless, since the HQC

285

In terms of the current version of section 23M, which was introduced with effect from 1 January 2015, a HQC is not excluded from its scope, which may then apply to restrict the interest deduction. It is, however, expected that this will be amended as it was not the intention to subject the HQC to tax on such interest earned from its foreign acquisitions. In the same vein it is necessary that HQCs are exempted from s8F and s8FA.

92

will be “liable to tax by virtue of its incorporation”, it will generally be

entitled to the benefits of the South African DTA network286.

The HQC regime could thus encourage treaty shopping by non-residents. The

question arises whether a court could conceivably condemn a treaty shopping

scheme by a non-resident to access a DTA with South Africa if the South

African Legislator has effectively sanctioned treaty shopping by non-residents

to access South African DTAs with other countries.

6 CURRENT MEASURES TO CURB TREATY SHOPPING IN SOUTH

AFRICA

6.1 USE OF DOMESTIC PROVISIONS

The use of domestic law provisions to prevent tax treaty abuse are endorsed by

both the OECD in its 2015 Final Report on Action 6 (as discussed above) and

the UN. 287 Both organizations consider that tax treaties may be subject to

domestic anti-avoidance rules in cases involving treaty shopping.288 The OECD

2015 Final Report on Action 6 also recommends that in order to prevent treaty

shopping where a person tries to circumvent the domestic tax law provisions

using treaty benefits, domestic anti-avoidance rules have to be applied. The

OECD 2015 Final Report on Action 6 outlines the avoidance strategies that fall

into this category, namely:289

Thin capitalisation and other financing transactions that use tax

deductions to lower borrowing costs;

Dual residence strategies (e.g. a company is resident for domestic

tax purposes but non-resident for DTA purposes);

Transfer mispricing;

Arbitrage transactions that take advantage of mismatches found in

the domestic law of one state and that are

286

Article 1 of the UK/South Africa DTA, which is the typical requirement to qualify as a resident of South Africa for DTA purposes.

287 See sections 1 and 2 of the Annex. For example, paragraph 9.4 of the Commentary to Article 1 of the OECD Model Convention states that countries do not have to grant the benefit of a double taxation convention where arrangements that constitute an abuse of the convention have been entered into and any such denial of treaty benefits may be achieved under either a domestic law or treaty-based approach.

288 Subject to the caveat in paragraph 9.5 of the Commentary on Article 1 of the OECD Model Convention that “...it is not to be lightly assumed that a taxpayer is entering into the type of abusive transactions referred to above.” In addition, paragraph 9.5 sets out the guiding principle that “…the benefits of a double taxation convention should not be available where a main purpose for entering into certain transactions or arrangements was to secure a more favourable tax position and obtaining that more favourable treatment in these circumstances would be contrary to the object and purpose of the relevant provisions.”

289 OECD/G20 2015 Final Report on Action 6 in Section A.

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o related to the characterization of income (e.g. by transforming

business profits into capital gain) or payments (e.g. by

transforming dividends into interest);

o related to the treatment of taxpayers (e.g. by transferring

income to tax-exempt entities or entities that have accumulated

tax losses; by transferring income from non-residents to

residents);

o related to timing differences (e.g. by delaying taxation or

advancing deductions);

Transactions that abuse relief of double taxation mechanisms (by

producing income that is not taxable in the state of source but must

be exempted by the state of residence or by abusing foreign tax

credit mechanisms).

As seen above, some of these avoidance strategies could also be utilized in the

context of South African DTAs, subject to the potential application of the

General Anti Avoidance Rules (GAAR) or other specific anti-tax avoidance

legislation.

The GAAR contained in sections 80A-L of the Income Tax Act290 provides a

significant weapon to SARS in attacking any transactions which seek to abuse

a DTA. Although South Africa’s GAAR provisions can be applied on any

impermissible tax avoidance arrangements which would result in a tax benefit in

a domestic context, they can also apply to international tax avoidance schemes

in a treaty context. In many situations this will not result in ignoring South

Africa’s obligations under the particular DTA, but using domestic tax law to re-

characterise the transaction. In this regard section 80B provides wide powers to

the Commissioner to determine the tax consequences of any “impermissible

avoidance arrangement” for any party by, inter alia, disregarding, combining or

re-characterising any steps in or parts of the impermissible avoidance

arrangement. South Africa can also apply the common law doctrine of

“substance over form” to prevent tax avoidance in a treaty context where the

parties are involved in sham or simulated transactions.

However, it could be argued that the application of such domestic provisions in

a treaty context amounts to treaty override.291 In terms of section 108(2) of the

Income Tax Act292, read with section 231 of the Constitution of the Republic of

South Africa,293 when the National Executive of South Africa enters into a

double tax agreement with the government of any other country, and the

290

Act 58 of 1962 291

Domestic law provisions to prevent tax treaty abuse are endorsed by both the OECD and the United Nations, both organizations consider that tax treaties may be subject to domestic anti-avoidance rules in cases involving treaty shopping.

292 Ibid

293

108 of 1996.

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agreement is ratified and published in the Government Gazette, its provisions

are as effective as if they had been incorporated into the Income Tax Act.294

Since both the GAAR and double tax treaties can be used to prevent tax

avoidance, there would be no conflict in purpose.

However to prevent treaty override disputes the OECD recommends that

the onus is on countries to preserve the application of these rules in their

treaties.295

South Africa should ensure it preserves the use of the application of

domestic ant- avoidance provisions in its tax treaties.

Regarding the issue of possible conflicts in the interactions between domestic

and treaty rules, it has been pointed out above the OECD 2015 Final Report on

Action 6 clearly states that treaties do not prevent the application of such

domestic anti-avoidance rules.

The other concern is that although the OECD recommends that treaty abuse

can be countered by domestic provisions, currently the preamble of the OECD

Model Tax Treaty does not include a reference to the objective to prevent tax

avoidance. It merely refers to the “prevention of fiscal evasion”. Likewise,

currently, the preamble to most of South Africa’s DTAs provides that the

purpose of the treaties is “for the avoidance of double taxation and the

prevention of fiscal evasion”. This does not include a reference to the object to

prevent tax avoidance. It merely refers to the “prevention of fiscal evasion”. As

indicated above, there is a significant difference between the concept of

“avoidance” and “evasion” of tax. 296 Therefore, whilst a DTA should be

interpreted in the light of its object and purpose stated in its preamble,297 it is

not certain that the object could be expanded to also include the avoidance of

tax if such object is not specifically stated. 298 It may be arguable that the

“prevention of fiscal evasion”, as stated in the preamble of many DTAs was

intended to cover a wider concept including tax avoidance. However, this may

stretch even the teleological approach to treaty interpretation.

The South African country International Fiscal Association Report (the SA IFA

Report) on 2010 concludes that since the relationship between DTAs and

domestic anti-abuse provisions has not been considered by the South African

courts, this relationship has to be determined according to South Africa’s

294

Ibid

295 Arnold at 245.

296 SARS Discussion Paper on Tax Avoidance and Section 103 of the Income Tax Act, 1962,

(2005) in para 221, where it refers to the definition of “tax evasion” by the OECD as encompassing “illegal arrangements through or by means of which liability to tax is hidden or ignored; also see Goyette at 766.

297 Article 33 of the VC.

298 Goyette at 766 – 768.

95

specific legal framework,299 i.e. the status of DTAs under South African law and

in relation to the provisions of the ITA.

The analysis above, on the status of DTAs under South African law, indicates

that our courts have expressed the view on several occasions that the OECD

Commentary on the OECD Model DTA should be taken into consideration

when a DTA provision is to be interpreted. In accordance with the OECD

Commentary, the domestic anti-tax avoidance rules of a contracting state may

be applied to counter the improper use of a DTA, provided it can be shown that

obtaining the tax benefit under the DTA was one of the main purposes for

entering into the transactions or arrangements and obtaining such a benefit

would be contrary to the object and purpose of the relevant provisions of the

DTA.300

Since the essential test under the general anti-tax avoidance rules (GAAR)

(contained in Part IIA of Chapter III of the ITA) is whether the sole or main

purpose of the transaction, scheme or arrangement is to obtain a tax benefit,

our courts would be able to apply the GAAR to counter DTA abuse, unless such

application could be regarded, under the circumstances, as contrary to the

object and purpose of the relevant provisions of the DTA. On the same basis,

the common law doctrines of substance versus form or the sham transactions

could be applied to counter artificial arrangements which are merely aimed at

achieving a tax benefit.

However, the object and purpose requirement may not be so easy to apply,

especially since the South African DTAs do not provide clearly in the preamble

of the DTAs that tax avoidance is one of the objects and purpose of the DTA.

Furthermore, there is uncertainty about the scope of the substance versus form

and sham doctrines to counter tax avoidance schemes, particularly if there is

some commercial rational for the arrangements.301

299

SA IFA Report at 723. 300

OECD Commentary, op cit, para 9.5 on page 61. 301

Erf 3183/1 Ladysmith (Pty) Ltd and Another v CIR, 1996(3) SA 942 (A), 58 SATC 229; Commissioner for SARS v NWK Ltd 2011 (2) SA 67 (SCA) where the court said: If the purpose of the transaction is only to achieve an object that allows the evasion of tax, or of a peremptory law, then it will be regarded as simulated.“; also see the subsequent decision in Bosch and Another v CSARS [2013] 2 All SA 41 (WCC) where the court remarked: “If there is no commercial rationale, in circumstances where the form of the agreement seeks to present a commercial rationale, then the avoidance of tax as the sole purpose of the transaction, would represent a powerful justification for approaching the set of transactions in the manner undertaken by the Court in NWK.”; see also the recent decision in Roshcon (Pty) Limited v Anchor Auto Body Builders CC 2014 JDR 0644 (SCA) where the Supreme Court of Appeal commented as follows:” If it meant that whole categories of transactions were to be condemned without more, merely because they were motivated by a desire to avoid tax or the operation of some law, that would be contrary to what Innes J said in Zandberg v Van Zyl in the concluding sentence of the passage quoted above, namely that: 'The inquiry, therefore, is in each case one of fact, for the right solution of which no general rule can be laid down.'”

96

As is recommended in the OECD 2015 Final Report on Action 6, it is submitted

that the wider scope of the DTA, apart from the mere general statement in the

preamble, should be included in all South Africa’s DTAs in order to determine

the object and purpose of particular provisions of the DTA. Concerns about

renegotiating a big number of treaties will be solved when South Africa signs up

to the Multilateral Instrument as recommended in Action 15 of the OECD BEPS

Project.

The advantage of applying domestic law to treaty shopping is that amendments

can be implemented in a timely manner. Such a domestic approach would have

immediate effect across South Africa’s entire tax treaty network, which would

facilitate a greater consistency in practice than would unfold if South Africa

were to rely exclusively on treaty-based solutions. 302 The effectiveness of the

GAAR has however not been tested in any court. Since GAAR was introduced,

there have been no reported cases applying GAAR. In this regard one may

wonder to what extent SARS could use it to prevent treaty-abusive

transactions. It is however notable that the proposed “principle purpose

provision” in the OECD 2015 Final Report on Action 6, is akin to the “main

purpose test” in the GAAR, which is applied to determine whether the

main/primary purpose of a transaction (or series of transactions of which the

transaction was a part) was to achieve a tax benefit, broadly defined. In effect,

the application of the GAAR to prevent treaty shopping, would be in line with

the OECD recommendations.

6.2 SPECIFIC TREATY PROVISIONS

6.2.1 THE BENEFICIAL OWNERSHIP PROVISION

Currently, the main specific treaty provision that is applied in South Africa’s

treaties to curb conduit company treaty shopping is the “beneficial ownership”

provision as set out in article 10, which deals with dividends, article 11 which

deals with interest and article 12 which deals with royalties. As explained

above, the term “beneficial ownership” is not clearly defined in the OECD Model

Tax Convention and nor is it defined generally in South Africa’s domestic tax

law (see discussion below). Article 3(2) of many of South Africa’s treaties

provides that, should a term not be defined in the treaty, it shall have the

meaning ascribed to it in terms of the domestic law of the contracting states.

The erstwhile definition of a “shareholder” in section 1 of the ITA, although it did

not specifically refer to “beneficial ownership”, defined a shareholder as the

302

OECD “Tax Conventions and Related Questions: Written Contributions from Members of the Focus Group on Treaty shopping” para 6.2.

97

registered shareholder, except where some other person is entitled “to all or

part of the benefit of the rights of participation in the profits, income or capital

attaching to the share so registered.” In such instance, the “other person” was

also deemed to be the shareholder. This definition was deleted with effect from

1 April 2012, when the new Dividends Tax legislation came into effect (section

64D – 64N of the ITA). The term “beneficial ownership” is now defined,

specifically in relation to dividends tax in section 64D of South Africa’s Income

tax Act, to mean “a person entitled to the benefit of the dividend attaching to a

share”. This is a very vague definition and no guidance regarding its

interpretation has been provided in the accompanying Explanatory

Memorandum. The definition applies only for purpose of the Dividends Tax

provisions of the ITA. It therefore does not apply to the rest of the ITA and/or to

other tax legislation. The concept of “beneficial ownership” is used in the

Securities Transfer Tax Act (STT Act).303 Although the concept is not defined in

the STT Act, the Explanatory Memorandum to the STT said the following in this

regard: “The concept of transfer relates to economic ownership, as opposed to the mere

registration of a security as in the case of a share registered in the name of a nominee.

For that reason transfer excludes any event that does not result in a change in beneficial

ownership.”

South African company law points out that the registration of shares in one

person’s name does not imply that such a person is the beneficial owner of the

shares since the registered holder may merely be a nominee. This was

confirmed in Dadabhay v Dadabhay304 and in Standard bank of South Africa Ltd

v Ocean Commodities Inc.305 However the real question which remains is under

what circumstances a conduit company could be regarded as a mere nominee,

as opposed to the real owner of the shares. In this regard, South African courts

could apply the criteria for the substance versus form and sham doctrines

developed by our courts to determine who a “beneficial owner” is for purposes

of the DTA provision in question. However, every case would have to be

considered on its own facts to determine whether the actual transactions may

be ignored on the basis that they represent a sham and to give effect to the real

transaction between the parties.

To date, only a handful of South African cases have touched on the meaning of

the concept of beneficial ownership. In Holley v Commissioner for Inland

Revenue 1947 (3) SA 119 (A), the main question for consideration was whether

the taxpayer received certain amounts (derived from assets he inherited from

his uncle) as a conduit for the benefit of his aunt, or whether he was the

beneficial owner of the funds in question, but with an obligation to make

303

Act No 25 of 2007 304

3 SA 1039 (AD). 305

1983 1 SA 276 (A).

98

payment to her of certain amounts. The Court held that his uncle’s Will created

a fideicommissum in favour of his aunt and that the taxpayer did not receive the

amounts in his personal capacity, but in a representative capacity on behalf of

his aunt.

In Standard Bank of SA Ltd and Another v Ocean Commodities Inc and Others

1980 (2) SA 175 (T), the Court considered the scenario where shares (in

compliance with Rhodesian exchange control rules) were registered in the

name of Standard Bank Nominees on behalf of two of the respondents. The

Court said the following regarding the ownership of the shares: “In respect of registered shares, a court can go behind the register to ascertain the

identity of the true owner. The fact, therefore, that the shares are registered in the name

of Standard Bank Nominees does not mean that it is the actual owner or that one cannot

look behind the register to ascertain the identity of the true owner.”

The Court then dealt with the position of the purchaser where shares are sold,

but not yet transferred: “Until registration of the transfer, however, the transferor or his nominee is a trustee of

the shares for the transferee. The trustee must act according to the instructions of the

transferee who becomes the beneficial owner of the proprietary rights in respect of the

shares by means of the conclusion of the contract of cession.”

In Commissioner, South African Revenue Service v Dyefin Textiles (Pty) Ltd

2002 (4) SA 606 (N), the Court considered the concept of beneficial ownership

in the context of a discretionary trust to determine whether the trust or the sole

beneficiary of the trust should be regarded as the shareholder of the shares in a

company. The Court made the following remarks in this regard: “The trustees admittedly did not have the beneficial ownership of these shares, but

nevertheless they were under an obligation to hold same and transfer them to a third

party if directed to do so by the taxpayer’s directors. This aspect of the matter points

away from the notion that at all material times the taxpayer was in reality the beneficial

owner of the shares.”

The Court rejected the view expressed in the lower Court, which held that the

trustees did not hold the assets of the trust on behalf of the trust as a separate

legal entity (which it is not) but on behalf of the sole beneficiary. It appears that

the High Court acknowledged that the trustees could not be regarded as the

beneficial owners of the shares, but it came to the conclusion above because

the trustees were under the obligation to hold the shares and potentially

transfer them to a third party if so directed to do so by the directors. Therefore,

the Court held that the trust was the shareholder and not the beneficiary. The

reasoning by the Court could imply that a beneficiary with vested rights under

the trust deed in respect of all the benefits of the shares, e.g. the right to share

in a portion of the dividends and any proportionate proceeds from the disposal

of the shares, would indeed be regarded as the beneficial owner of the shares

in the proportion to his entitlement. However, it should be noted that the trust

99

deed in question specifically provided that the “shares shall be held by the trust

as nominees and subject to any terms and conditions as laid down by the board

of directors of Dyefin Textiles (Pty) Ltd.”

Although all the remarks regarding beneficial ownership in the cases

considered above were obiter, it appears that the courts commonly accept the

beneficial ownership concept in those instances where a party holds assets as

nominee, agent or trustee for the beneficial owner. It is submitted that the

scope to interpret the meaning to be wider than such nominee or agency

relationships is thus very limited.

Despite the above domestic definitions, for treaty purposes the meaning of

beneficial ownership should not be limited to a narrow South African

interpretation. Care should be taken to ensure that it carries a wide international

meaning that is in line with the guidelines offered by the OECD.

Nevertheless as explained above, internationally it is not precisely clear what

the concept of “beneficial ownership” means. We have pointed out that section

233 of the Constitution of the Republic of South Africa requires that a court,

when interpreting legislation, must prefer any reasonable interpretation of the

legislation that is consistent with international law over any alternative

interpretation that is inconsistent with international law. Therefore, our courts

will consider the interpretation by foreign courts of new concepts used in the

international arena. However, foreign judgments must be considered taking into

account the relevant legislation and specific context. In the context of a DTA,

our domestic courts and foreign courts often refer to the OECD Commentary on

the OECD Model DTA for support of an interpretation. Therefore, the

comments of the OECD Commentary noted above should also be considered

by a court in considering the application of the beneficial ownership criterion

used in a DTA.

As illustrated in the discussion of the international approaches to treaty

shopping, the analysis of the foreign case law shows that there is no universally

accepted interpretation of the “beneficial ownership” concept and courts in

different countries have adopted different views in this regard. The UK Indofood

case306 is often referred to as support for the “expansion” of the concept of

beneficial ownership to give effect to the “substance of the matter”. However,

the decisions of the Canadian courts in the Velcro Canada Inc. v The Queen307

and Prevost Car Inc. v Her Majesty the Queen, 308 cases indicate a more

formalistic approach,309 in line with the South African courts cases analysed

306

See the analysis of the case under the analysis of the UK approach. 307

2012 TCC 57. 308

2008 TCC 231. 309

See the analysis of the Canadian approach above.

100

above. It is therefore most likely that the South African courts would apply the

tests for beneficial ownership as confirmed in the Velcro case, i.e. the attributes

of beneficial ownership are “possession”, “use”, “risk” and “control”. If these

attributes are considered in the context of a treaty shopping arrangement, they

could lead to a conclusion that the intermediary company in the country which

has a beneficial DTA with South Africa did not qualify for DTA relief, since it

may not have sufficient control or use of the funds if it was clearly required to

immediately on-distribute the dividends, interest or royalties to a third party.

However, the factual circumstances would have to be taken into account to

determine whether the intermediary company may fulfil the requirements of a

beneficial owner.

Nevertheless the decisions in the Prévost and Velcro cases show that there are

challenges in effectively applying the beneficial ownership provision to prevent

treaty shopping. It is therefore submitted that the “beneficial ownership”

provision cannot be fully relied on in South Africa to prevent treaty shopping.

It should be noted that although the “beneficial ownership” has proved

ineffective in curbing conduit company treaty shopping, the OECD does not

recommend that this provision should be completely done away with. The

OECD explains that this provision can still be applied with respect to certain

matters, but it cannot be relied on as the main provision to curb treaty shopping.

In this regard, the concept of “beneficial ownership” can still be applied with

respect to the relevant income in articles 10, 11 and 12.

Where that is the case, in the South African context, it is important that

SARS should address the practical application or implementation of the

tax treaty by coming up with measures of how a beneficial owner is to be

determined. This could be achieved by introducing measures such as:

o Beneficial Ownership Certificate;

o Tax Registration Form;

o Permanent Establishment Confirmation Form.

o A definition of beneficial ownership in section 1 of the Income Tax

Act, which is in line with the treaty definition as set out in the

OECD MTC.

6.2.2 THE LIMITATION OF BENEFITS PROVISION

Apart from the “beneficial ownership” provision, South Africa has a “limitation of

benefits” (LOB) provision in its treaty with the United States, as the United

States chooses to use this provision in its double taxation treaties. The basic

premise of the LOB provision is that every person in a chain of ownership must

be entitled to the benefits of the treaty (i.e. must be a resident of either of the

two contracting states). Only persons satisfying specific and objective tests are

eligible for treaty benefits. The premise underlying this provision is that if any of

101

the objective tests for eligibility are satisfied, the requisite treaty shopping

motive is not present then treaty benefits should be granted.310 Although more

targeted and certain in application, this LOB approach can also be over-

inclusive and generally contains a provision enabling contracting states to grant

treaty benefits on a discretionary basis in appropriate circumstances.

7 RECOMMENDATIONS TO ADDRESS TREATY SHOPPING IN SOUTH

AFRICA IN LIGHT OF 2015 FINAL REPORT ON ACTION 6

To ensure protection against treaty abuse, including treaty shopping the OECD

recommends that a minimum level countries should include in their tax treaties

an express statement that their common intention is to eliminate double

taxation without creating opportunities for non-taxation or reduced taxation

through tax evasion or avoidance, including through treaty shopping

arrangements; and countries should implement this common intention through

either: 311 - using the combined LOB and PPT approach described above; or


- the inclusion of LOB rule supplemented by a mechanism (such as a restricted PPT

rule applicable to conduit financing arrangements or domestic anti-abuse rules or

judicial doctrines that would achieve a similar result) that would deal with conduit

arrangements not already dealt with in tax treaties. 312

On the common intention of tax treaties:

It is recommend that in line with this recommendation, South Africa

ensures that all its treaties refer to the common intention that its treaties

are intended to eliminate double taxation without creating opportunities for

non-taxation or reduced taxation through tax evasion or avoidance,

including through treaty shopping arrangements. The costs and

challenges of re-negotiating all treaties will be alleviated by signing the

multilateral instrument that is recommended under Action 15 which will act

as a simultaneous renegotiation of all tax treaties.

Feasibility of applying the LOB provision in South Africa

The proposed LOB is modelled after the US LOB provision.

Essentially, the LOB provision requires that treaty benefits (such as

310

These specific and objective tests are similar in principle to certain of the exceptions discussed above in the context of some general anti-treaty shopping approaches which are likely to be over-inclusive. However, countries using objective rules in LOB articles to determine eligibility for treaty benefits would also tend to provide more specific guidance on the interpretation of those rules in other authoritative sources. This is the case in the US where in practice taxpayers and practitioners refer to the US Model Convention and other treaties for specific and technical guidance in addition to the technical explanation for any particular treaty.

311 OECD/G20 2015 Final Report on Action 6 at 10.

312 OECD/G20 2015 Final Report on Action 6 at 22 -23.

102

reduced withholding rates) are available only to companies that meet

specific tests of having some genuine presence in the treaty country.

However such an LOB provision has not been applied in many DTAs

other than those signed by the USA, and even then, the provisions

vary from treaty to treaty. South Africa for instance (one of the few

African countries that has a DTA with the USA - others are Egypt,

Morocco and Tunisia)313 has an LOB provision in article 22 of its 1997

DTA with the USA.314 The structure of the LOB provision as was set

out in the September 2014 the OECD Report 315 on Action 6 was

however criticised for its complexity. Even in the US, application of the

LOB has given rise to considerable difficulties in practice and is

continuously being reviewed and refined.316 In its 2015 Final Report,

the OECD considered some simplified versions of LOB provisions to

be finalised in 2016.317

If the simplified versions of the LOB provision are found feasible when

complete, South Africa should consider adopting the same.

Feasibility of apply the PPT test in South Africa

The PPT rule requires tax authorities to make a factual determination as

to whether the principle purpose (main purpose) of certain creations or

assignments of income or property, or of the establishment of the person

who is the beneficial owner of the income, was to access the benefits of

a particular tax treaty.

As alluded to above, the factual determination required under the

“principle purpose test” is similar to that required to make an “avoidance

transaction” determination under the GAAR in section 80A-80L of the

Income Tax Act – in particular, whether the primary purpose of a

transaction (or series of transactions of which the transaction was a part)

was to achieve a tax benefit, broadly defined. Since the two serve a

similar purpose, the GAAR can be applied to prevent the abuse of

treaties. Based on that one could argue that there is no need for South

Africa to amend its treaties to include a PPT test since the GAAR could

serve a similar purpose. Nevertheless, much as the OECD Final Report

clearly explains that domestic law provisions can be applied to prevent

treaty abuse, there could be concerns of treaty override if South Africa

applies it GAAR in a treaty context. Besides South Africa’s GAAR may

313

IRS ‘United States income tax treaties - A to Z’. Available at https://www.irs.gov/Businesses/International-Businesses/United-States-Income-Tax-Treaties---A-to-Z accessed 18 February 2016.

314 Published in Government Gazette No. 185553 of 15/12/1997.


Benefits in Inappropriate Circumstances Action 6: 2014 Deliverable” (2014). (OECD/G20 September 2014 Report on Action 6).

316 PWC “Comment on DTC BEPS First Interim Report (30 March 2015) at 20.

317 OECD/G20 2015 Final Report on Action 6 n 135 above in para 25.

https://www.irs.gov/Businesses/International-Businesses/United-States-Income-Tax-Treaties---A-to-Z

https://www.irs.gov/Businesses/International-Businesses/United-States-Income-Tax-Treaties---A-to-Z

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not be exactly worded like a similar provision with its treaty partner. It is

thus recommended that South Africa inserts a PPT test in its tax

treaties.318 Required re-negotiation of treaties can be effected by signing

the Multilateral Instrument that could have a standard PPT test as is

recommended in Action 15 of the OECD’s BEPS Project.

It is also worth noting that Canada implements a main purpose test in many of

its recent treaties,319 and that the main purpose test is actually applied in some

of South Africa tax treaties. For example the treaty with Brazil provides in article

11(9) that:

“The provisions of this Article shall not apply if it was the main purpose or one of

the main purposes of any person concerned with the creation or assignment of

the debt-claim in respect of which the interest is paid to take advantage of this

Article by means of that creation or assignment”.

This article requires the tax authorities to determine whether the main or one of

the main purposes of such “person” was “to take advantage” of Article 11 of the

treaty “by means of that creation or assignment”. The intention of Article 11(9)

is to deny the benefits of, inter alia, Article 11 where transactions have been

entered into for the main purpose of restricting the source state’s (Brazil’s)

ability to tax the interest income. This is confirmed by the OECD Commentary

on Article 11(9), which states that: “The provision has the effect of denying the

benefits of specific articles of the Convention that restrict source taxation where

transactions have been entered into for the main purpose of obtaining these

benefits. The Articles concerned are 10, 11, 12 and 21…” (Emphasis added).

o Article 11(9) of the treaty is therefore aimed at preventing “treaty

shopping” in circumstances which circumvent the source state’s (Brazil)

ability to impose withholding tax on income flows from the source state to

the resident state (South Africa).

o In particular, in the context of Article 11, it is aimed at preventing a

situation where a source state, such as Brazil imposes withholding tax on

interest paid to low tax jurisdictions at the rate of 25%. If the holder in a

low tax jurisdiction of a debt instrument issued by a Brazilian resident

transfers the debt instrument to, say, a South African resident in order to

ensure that Brazil may only impose withholding tax at the rate stipulated in

Article 11(2) of the treaty, namely, 15%, then the provisions of Article

11(9) of the treaty should apply.

318 Arnold at 245.

319 For example, paragraph 7 of Article 10 (and paragraph 9 of Article 11 and paragraph 7 of Article 12) of the Canada-Hong Kong tax treaty reads as follows:

“A resident of a Party shall not be entitled to any benefits provided under this Article in respect of a dividend if one of the main purposes of any person concerned with an assignment or transfer of the dividend, or with the creation, assignment, acquisition or transfer of the shares or other rights in respect of which the dividend is paid, or with the establishment, acquisition or maintenance of the person that is the beneficial owner of the dividend, is for that resident to obtain the benefits of this Article.”

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o This may be distinguished from the provisions of Article 11(4)(b) of the

treaty, which specifically incentivises a resident of South Africa or Brazil to

invest in government bonds issued by the other Contracting State.

It is recommended that South Africa follows the approach in its treaty with Brazil

by ensuring it has a PPT clause in all its future treaties. This this would imply

re-negotiating all its treaties; which could be done under the umbrella of the

multilateral instrument that the OECD is working on under Action 15.

Apart from the above, in light of the OECD recommendations in

paragraph 5.2 above, it is also recommended that South Africa ensures

its tax treaties also cover the targeted specific treaty anti-abuse rules in

specific articles of its tax treaties (as pointed out in the OECD Report) to

prevent treaty abuse where a person seeks to circumvent treaty

limitations.

South Africa should also take heed of the OECD recommendations on

tax policy considerations that, in general, countries should consider

before deciding to enter into a tax treaty with another country or to

terminate one (see discussion in paragraph 5.5 above).

Documents

ANNEXURE 6 DAVIS TAX COMMITTEE: SECOND … BEPS Final... · - the inclusion of the PPT rule or; 3 OECD/G20 Base Erosion and Profit Shifting Project “Preventing the Granting of Treaty